Switching RRSPs to RRIFs

Many factors come into the calculation equation when determining when to convert your Registered Retirements “Savings” Account (RRSP) into a Registered Retirement “Income” Account.  An RRSP is used as a way for many Canadians to save for retirement and is essential for individuals without an incorporated business or a registered pension plan.

After all the years of saving, many people are still somewhat uncertain of when to begin drawing the savings out as regular income through a RRIF account.  Maximum deferral to age 72 can result in a shock in the rise in taxable income once RRIF minimum withdrawals begins.

To illustrate we will use Martin Hitchon, who turned 71 this year and is required to convert his RRSP account to a RRIF account before December 31 but is not required to take a payment in the first year.  Martin currently has $500,000 in his RRSP that will be rolled into his RRIF account.  Next year Martin is required to withdraw 7.48 per cent of the value of his account on December 31 of the year he turned 71.  The required annual minimum payment is stated as a percentage of the previous year end value.  These percentages increase slightly until age 94 where the maximum rate of 20 per cent is reached.  Assuming Martin’s portfolio is at $500,000 at the end of the year, he will have a minimum payment equal to $37,400 that will be considered taxable.

The perfect RRSP strategy is to contribute in high income and upper tax bracket years, and to pull funds out when you’re in a lower tax bracket.  The sudden increase in income with RRIF minimums left until age 72 may result in many people being in a higher tax bracket.  Many people may be wondering if waiting until age 72 is the best decision, especially knowing that this income will be on top of CPP, OAS, and other income.   The purpose of a financial plan when you’re younger is to map out the required savings to reach your shorter term goals and projected retirement needs.  The plan may also include a protection strategy for your family.  As you approach retirement the focus often shifts to understanding where cash flows will come from and which pools of capital you should access first.

Our clients who have taxable income over $125,000 annually are typically advised to wait until age 71 to convert and to take the first payment at the end of the year in which they turn 72.  In setting up the RRIF for high income couples we elect to use the younger spouses age to obtain maximum deferral.   Once clients are in the top marginal tax bracket (43.7 per cent in BC) the best strategy is to defer the tax liability by continuing to tax shelter within the registered account.

When income is expected to be below $125,000 then the decision on whether to convert your RRSP early to a RRIF is not straight forward.  Once you convert to a RRIF you are then obligated to begin taking income out for all future years.  It is possible to convert from a RRIF back to an RRSP prior to age 71 if your circumstances change.  The following are the key items to discuss when we are talking with clients:

■ Watching Thresholds – The Guaranteed Income Supplement (GIS) and the allowances are not based on net worth.  Many high net worth individuals have equity in real estate, corporations, and trusts that result in personal net income being low.  The GIS and the allowance stop being paid at $39,600 and $30,576, respectively.  Pulling funds out of an RRIF early could result in you losing these benefits.  Pensioners with an individual net income above $69,562 will have a portion of their Old Age Security payments clawed back if RRIF income is taken early.  The full OAS pension will have to be repaid if net income is $112,966 or above.   Projecting your income in the future will help in mapping out a strategy factoring in these thresholds.

■  Ratio of Non-Registered to Registered – Ideally as you enter retirement you have savings in both non-registered and registered accounts.  The non-registered savings are already after tax dollars and can be accessed with less tax consequences then registered funds.  This is especially important as you factor in potential lump sum needs in the future (i.e. new car, roof repair).  The greater the funds you already have in non-registered funds the easier it is to manage emergencies and to smooth out your income during retirement while at the same time fulfilling your cash flow needs.  If you have limited non-registered funds then earlier withdrawals may make sense.

■  Liquid Assets – High net worth is often locked up in real estate or assets that are not easily converted into cash.  Often at times the number one deciding factor in whether to pull funds out of a RRIF early is a result of cash flow needs and access to liquid funds.

■ Tax Free Savings Account (TFSA) – People without TFSA or non-registered accounts should consider pulling $5,000 out of their registered accounts annually to fund the Tax Free Savings Account.  Growth in a TFSA can be tax sheltered while at the same time building up a reserve of funds for you to access if an emergency arises.

■ Pension Income Amount – Beginning at age 65, investors without any other qualifying pension income are able to effectively withdrawal $2,000 annually from their RRIF account tax free.  This is because the income would be offset by what is referred to as the pension income amount.  Couples can withdrawal $4,000 annually with no taxes.

■ Pension Splitting – With the introduction of pension splitting the strategy for many couples has changed.  Up to fifty per cent of eligible pension income can be shifted from the high income spouse to the lower income spouse.  RRIF withdrawals beginning at age 65 qualifies as eligible pension income.

■ Couples – RRIF accounts are 100 per cent taxable upon death.   Nearly half of a RRIF balance of a single individual could go to taxes.   Couples have significant less risk of paying a large tax bill as they have the ability to elect a tax free roll-over a RRIF to the surviving spouse provided their spouse is named as a beneficiary.  This becomes trickier with second/third marriages with children from previous relationships/marriages.  The tax on the RRIF would be deferred when a spouse is named until the second passing and would likely be depleted slowly over time at more favourable marginal tax rates.

■ Other Estate Factors – Various other estate factors can result in different strategies for your RRIF account.  Some people may leave a RRIF account to a charity which would offset the large tax liability.   Insurance (i.e. joint last to die) is often a useful tool to cover the tax liability for a RRIF’s deemed disposition upon death.  Understanding your own health and family genetics is a factor that should be considered in the timing of when to withdrawal funds from your RRIF.