Tax Smart Retirement Funding

Ross McShane I wrote an article for CMS in 2012 called Generating Cash Flow during Your Golden Years. It may not have applied to your situation then but it may now. I continue to see an increasing number of individuals and couples who are at a stage of life where they are gearing down for semi-retirement or full retirement.

I feel it is worthwhile to touch on this topic again due to the changing landscape. For instance, personal tax rates have increased dramatically, the top marginal bracket now kicks in at a much lower amount, and we have enjoyed a healthy run in the equity markets and a build-up of wealth inside TFSAs. The list could go on and on.

A Typical Cash Flow Generation Strategy Will Often Include The Following Objectives:

Covering annual recurring and non-recurring expenditures (no kidding)

Using up lower tax brackets in early retirement to minimize tax in late retirement

Splitting income to reduce the tax bite

Preserving Old Age Security (OAS) to the extent possible

Assisting adult children with financial support if needed

Will your fixed sources of income such as pensions, annuities, CPP/QPP, and OAS be sufficient to carry the load? Likely not unless you are fortunate enough to have a generous defined benefit pension plan. If yes, you will have a growing surplus of investments. Ask yourself: What will I use my investments for? Assisted care? To transfer to my beneficiaries? Favorite charities? Take steps now to do this tax efficiently.

The likelihood, however, is that most of us will need to draw down on our various “pots of money” in order to manage the gap (the difference between after-tax fixed sources of income and expenditures). Traditional thinking was typically to draw first from the non-registered account (money that has already been taxed) and defer tax on the RRSPs for as long as possible.

It is more complicated now for a variety of reasons that we will review. It is important to note that every situation is different and cannot be solved with a cookie cutter approach. A big picture approach is required. Your lens must allow you to look beyond this moment in time, with a sense as to how your financial picture will look down the road.

Important Considerations:

Using up lower tax brackets in early retirement to minimize tax in late retirement

The top marginal tax rate in Ontario is 53.5% on ordinary income when your taxable income exceeds $220,000. Back in 2012 it was 46.4% between $132,406 and $500,000 at which point it increased to 47.97%.

This higher tax rate is of concern to those who may be reporting income beyond $220,000 today or may potentially see a chunk of their estate taxed at the top tax rate.

For those who anticipate that their income and tax bracket will be greater in the future, the concept of using up your lower tax brackets today deserves considerable attention. The idea is to manufacture taxable income today that is subject to tax but hopefully in a lower tax bracket than it would be subject to later on. For instance, it is not uncommon to see an individual withdraw from his/her RRSP in early retirement to increase taxable income to $87,559 (the top of the 33.89% tax bracket in Ontario) to avoid having this income taxed at 43% or more later on. Of course, if OAS is being drawn, the decision is likely to top up income to the bottom of the OAS threshold which is $74,789 of net income in 2017.

CPP and OAS may be delayed until age 70 with an enhanced benefit

Decisions regarding when to draw on CPP include life expectancy and cash flow. Unlike CPP, OAS is a means-tested benefit and starts to be clawed back when your income reaches the threshold. A recent development allows you to defer OAS to age 70 which is a good strategy if your income is in clawback territory.

For instance, you may still be working, or maybe you have initiated an early RRSP withdrawal strategy as mentioned above to lower minimum required withdrawals from your RRIF at age 72. Perhaps you established a corporation to report business income but it is now inactive. You may have retained earnings that you are drawing out of your corporation at an accelerated pace in order to wind it up sooner than later to simplify your affairs and eliminate compliance costs. Again, it may make sense to defer OAS as your net personal income will be temporarily inflated while you draw from the corporation.

Future inheritances

What do you anticipate? How much? Timing? How will a large inheritance impact your situation? When invested at the personal level, will the annual income from the investments be taxed at a high rate? Will it mean that RRIF withdrawals will be taxed at a higher rate as a result?

Possible tax implications of drawing on insurance policies

“My insurance person told me that I can withdraw from my corporate-owned policy tax-free”. Did your accountant remind you that withdrawals from the corporation could be taxed as a dividend at the personal level? Has this been factored in? Did you factor in the borrowing cost if you are leveraging the policy? It may be best to leave the policy to your estate as a means of passing surplus wealth along to your beneficiaries more tax efficiently?

Flexibility of the corporate structure – can you pay dividends to family members to split income

Let’s say you want to help your adult children out financially or you plan on leaving corporate funds to them through your estate. If your adult children are shareholders and in a lower personal tax bracket than you are in today, and lower than their anticipated brackets later on, consider paying them a dividend now. Yes, you give up some tax deferral by paying tax today but this could well be a better result to avoid having these funds taxed at a much higher rate through your estate. Plus, they could use the dividend to fund their TFSAs allowing for tax-free investment growth. Inside the corporation investments are taxed as passive income.

TFSAs

When first introduced in 2009 they didn’t receive much fanfare. In 2017 an individual will have accumulated $52,000 of TFSA contribution room. Factor in rising equity markets along the way and the value could be worth much more if you have been investing consistently.

Depending on your situation, the TFSA could be the last bucket to draw on. Continued annual contributions create a tax-free emergency fund or eventual inheritance for your beneficiaries.

Ross McShane, CPA, CGA, CFP, RFP, CIM is Vice President, Financial Planning for Doherty & Associates in Ottawa, Ontario.