Back to the topic at hand. In late December I was updating a retirement spreadsheet I have for changes in my current circumstances and future income tax minimization.
RRSPs are Great while you are Working, not as Great when you Retire
I think most readers will know this, but to quickly recap, contributions to a RRSP result in a tax deduction in the year made (or subsequent year if you don’t fully claim the contribution) and your RRSP grows tax-free until you convert the RRSP by the end of the year you turn 71. For most people, a RRSP works well as their contributions are made at a time their marginal tax rate is higher than they expect in retirement, so they have an ultimate tax savings. Despite the tax effectiveness of your RRSP, the value is somewhat of an illusion, as you are also accumulating a large, deferred tax liability, as the entire value of your RRSP will be taxable in your retirement.
There are a couple options for a RRSP when your turn 71, including a lump sum withdrawal, the purchase of an annuity or the option most people select, converting their RRSP into a Registered Retirement Income Fund (“RRIF”).
Once you convert your RRSP into a RRIF any future withdrawals are subject to income tax (you are now paying tax on your accumulated lifetime contributions and earnings that were tax-free in your RRSP) a sometimes nasty surprise in quantum for some people. You must start drawing your annual minimum RRIF payment by December 31 of the year following the year you establish your RRIF. Since you will typically still be 71 the year following the establishment of your RRIF, the minimum withdrawal will be 5.28% (you may be able to use your spouses age to lower the withdrawal rate) and will rise each year to around 10.2% by 88 and the withdrawal rates will continue to rise dramatically after age 88.
Each year this minimum withdrawal will be taxable on top of any old age security, CPP, pension income and any other investment or other type of income you earn. The marginal tax rate on these RRIF withdrawals can be substantial depending upon your financial circumstances. Luckily for many, you can elect to split your RRIF pension income with your spouse (Form T1032 -Joint Election to Split Pension Income) and thus, you can often lower your effective family tax rate through this election. However, even with the election, the deferred tax hit on your RRIF withdrawals can still be substantial.
Corporations – You have only Paid Part of the Tax
As noted above, I was struck by the quantum of my tax liability for not only my RRSP, but the investments retained in my PC. For purposes of this discussion, consider a PC to be the same as any corporation you may have. Most active companies will have paid corporate tax historically anywhere from say 12% to 26%, depending upon the corporate province of residence. You have thus deferred anywhere from say 20%-40% in tax by keeping the earnings in your corporation (again depending upon the province). Assuming you need to take money from your corporation in retirement, you will then have to deal with this deferred tax liability when you take the money (typically as a dividend).
Similar to a RRIF, you will owe income tax on this deferred tax (the deferred tax is less than your RRIF, since the corporation paid some tax, whereas you paid no tax on your RRSP). If you have been earning investment income in your corporation, you may have some tax attributes like refundable tax to reduce your tax liability, but the original money earned and deferred by the original active company is still subject to a tax hit even though it is now co-mingled with investment income earned on these deferred earnings. Without getting technical, you still have a large, deferred tax liability as you withdraw funds from your corporation.
Income Taxes and Your Retirement Withdrawal Rate
I have written a couple times on how much money you need to retire. In 2014, I wrote an extensive six-part series titled How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! (The links to this series are under Retirement on the far-right hand side of the blog).
In Part 1 of the original 2014 series, I had a section on some of the criticisms of the 4% rule. The first and the most impactful limitation being the model does not account for income taxes on non-registered accounts and registered accounts Note: many of the studies I discuss in both 2014 and again in 2021, still support that the 4% withdrawal works despite any income tax limitations, but I thought it important to reflect this limitation of the rule.