Early RRSP Withdrawal - Part 1

Besides general questions regarding the meaning of life, whether the Blue Jays have a chance of making the playoffs in 2018 and how to avoid Old Age Security (OAS) pension clawbacks, many of my clients like to talk about the best way of withdrawing money from their Registered Retirement Savings Plans (RRSPs). The answer is, it depends. Although this sounds exactly like the sort of non-answer you’d expect from a man with a law degree, this time it is the truth. Rather than switching the conversation back to the benefits of meditation or whether Devon Travis will return to man second base next year for the boys in blue, I will explain what I mean and what factors to consider when deciding how to minimize taxes on your RRSP nest egg. Although your picture may still be a little murky by the time I’m done, I’m hopeful that by reading this article and those to follow over the ensuing months, I will provide you with enough information to guide you towards the answers you seek.

By way of preamble, I have been writing this article in my mind for over a year, ever since getting an email from one reader who’d read one of my RRSP planning articles last year in his local library. He disagreed with a few of my assertions and generally argued that clients are always better off leaving money in their RRSPs as long as possible. Fortunately, for my clients’ sake and my own self-respect as a planner, after reviewing his comments and my article, I was able to find the flaws in his various arguments, reaffirm my own conclusions and then respond to him before returning to my thoughts to OAS pensions and Blue Jays’ baseball. I also planned to write an article showing why it isn’t always such a good idea to keep the money growing in your RRSP as long as possible after reviewing his elaborate mathematical calculations that were unfortunately flawed and incomplete.

That day has now finally come. Today’s article focuses on explaining why leaving money in your RRSP as long as humanly possible might be an expensive mistake for some of us, although not always. As the old cliché says, the devil is in the details. There will be other articles in this series to follow that will provide the factors to consider when reviewing your own situation to apply these general principles to your own specific situation, but my mission today is to set the stage for what is to follow.

Overview

Although tax planners generally love taxation procrastination (i.e. delaying triggering tax bills as long as possible), there are exceptions to this rule. First, if you are in a significantly lower tax bracket now than you expect to be in the future, then it might make sense to take your lumps now if it means avoiding greater pain later.

People who withdraw money from a RRSP ahead of schedule are willing to accept a smaller, nimbler, tax-efficient portfolio with the expectation that it is worth more to them or their heirs than a larger RRSP or Registered Retirement Income Fund (RRIF) portfolio might be after taxes, particularly if forced to pay the combined marginal tax rate of 53.53% in Ontario or 47.7% British Columbia if the income falls in the highest tax bracket at death.

When determining whether early withdrawals make sense, you have to accept that you are missing out on the growth on the portion of your RRSP investments you are now paying in taxes that would have otherwise stayed invested. You must be confident that, although you will now have less total dollars working for you, the benefits of minimizing the tax hit by triggering a bill earlier than necessary will compensate you for the lost pre-tax compound growth you would have received by putting off your day of reckoning. In other words, you need to be willing to work with a smaller investment portfolio than would have been the case if you’d left things well enough alone in the hopes that it will be worth more after-tax than if you’d kept your RRSP intact.

On a related note, you need to compare how the portfolio you create when you withdraw money ahead of schedule from your RRSP and reinvest it will be taxed going forward compared to your RRSPs. As Canadians know or will find out the hard way, everything inside your RRSPs will be fully taxed as income upon withdrawal. On the other hand, if the extra money withdrawn from your RRSP is invested in your Tax-Free Savings Account (TFSA) or in a non-registered account that pays eligible dividends from Canadian companies or is geared towards capital gains, then your new portfolio will have far less tax drag per dollar than your RRSP. If you invest for capital gains, you will only pay tax on 50% of the growth, compared to 100% if you owned the same investment inside an RRSP.

Continuing with the topic of taxation, eligible dividends can be even more tax efficient for many Canadians when owned in an open account. In Ontario, if your income is below approximately $46,000, you not only don’t pay tax on these dividends; in fact, you receive money back from the government instead. Moreover, if your income is between about $46,000 and $74,000, then the top tax rate on dividends “soars” to only 6.39%. In comparison, if those dividends were paid inside your RRSP, they will eventually be taxed at 29.65% if withdrawn in that tax bracket. In other words, if paid inside your RRSP, you could easily be paying more than 4 times as much tax per dividend dollar than if you received the dividend in your non-registered account upon withdrawal. If that money stays put until death, however, that’s when things get unpleasant. If you are in the top tax bracket at that time, as is not uncommon, that same dividend dollar would be taxed at 53.53%, which means paying more than 8 times more tax than if you’d earned that dividend early in your open account.

Early RRSP Withdrawals

An Example:

Here is a very basic example with very approximate numbers. I will use combined Ontario marginal tax rates. Consider an Ontario investor around 60 years of age with $1,000,000 in his RRSP and about $46,000 in other income, which is enough to satisfy his needs, so that any additional withdrawals can be reinvested in his non-registered account for the future. He earns 6.5% per year on his RRSP investments, 3.75% each in capital gains and eligible dividends and, like many Money Saver investors, plans to buy and hold. He is debating between pulling out $40,000 per year for the next 12 years before he officially must convert his RRSP to a RRIF and commence making withdrawals or, alternatively, leaving things well enough alone until he is forced to start withdrawing RRIF funds.

Assuming he pays 30% tax on the early withdrawals, he would have $28,000 per year left to reinvest if he makes his withdrawals each January 1st, Focusing first on the 3.75% yearly capital growth he would earn on his yearly $28,000 non-registered contributions, this amounts to $414,739 after 12 years, of which $78,739 is unrealized capital gains. This ignores any of the dividends this portfolio generates.

Turning to these dividends payments, each year’s withdrawal would pay dividends at 3.75% going forward (which I show as 3.45% after 8% in taxes) which I assume will be reinvested at no cost, such as through a Dividend Reinvestment Plan (DRIP), so that each year’s dividend stream increases.

To crunch the total value of the dividends and their growth, this required calculating 12 separate income streams, as the first year’s dividends will have another 11 years to grow, while the last won’t grow at all using my calculations. There will also be 3.75% capital growth if these dividends are reinvested. Anyway, for the purposes of this calculation, I will assume that the dividends are worth an additional $85,755 after about 12 years with $10,407 in unrealized capital gains. In other words, after including the $414,739 in capital growth on the non-dividend portion, our client has a total non-registered portfolio worth $500,494. If he died at that time and was in the highest tax bracket, this would leave him with or $476, 634 after taxes, since the bulk of the portfolio was already taxed along the way.

In addition to the non-registered portfolio our client has created with the early withdrawals, his RRSP is still alive and well. Despite the series of $40,000 in withdrawals, the portfolio would still have $1,434,267 left 12 years later, as the amount he withdrew was actually less than his portfolio’s annual growth. If he died at that point and forced to pay tax on that balance at 53.53%, he would be left with only $666,503. Accordingly, when adding this amount to the $476,634 after-tax value of his non-registered portfolio, their combined after-tax value is worth $1,134,137.

On the other hand, if he does nothing and lets his RRSP grow unchecked for the next twelve years, it would grow to a value of $2,129,096. At first blush, this may seem to be the way to go, as it is almost $200,000 more than the pre-tax value of his non-registered portfolio and his smaller RRSP if he went with the early withdrawal option. The after-tax values tell a different story. When decimated by tax at 53.53% at death, his RRSP is only worth $989,380 after taxes, which is actually $144,741 less for his heirs than if he’d started his withdrawals early.

Of course, this is a very specific example and only shows that in the right circumstances withdrawing coins from your RRSP early can mean more dollars in your (or your heirs’) back pockets later. For example, if our intrepid investor wasn’t investing as tax efficiently in his non-registered portfolio, such as if he was earning primarily interest or realizing his capital gains more frequently, the numbers won’t be as attractive and he might have been better off keeping the money in his RRSP and delaying his day of reckoning.

As well, if our investor had lived to a ripe old age, he would have had the chance to get more of his RRSP or RRIF money out at rates lower than the maximum, thus improving his result. In the end, this example is merely to show that sometimes withdrawing money from your RRSP early can be a good thing, rather than suggesting that it is always the way to go.

Conclusion

Now that I’ve hopefully shown that sometimes pulling money from your RRSP ahead of schedule can make a huge difference in the right circumstances, my next few articles will help you identify the factors to consider when looking at your own account statements and deciding whether to let your RRSPs grow or to start tapping into your dough. Until then, I’ll direct my thoughts to whether or not the Blue Jays will keep or trade Josh Donaldson.

Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.