In January, I wrote a post titled RRSPs and Corporations – Your Silent Creeping Tax Liability. The blog noted that whether you are currently working, near retirement or in retirement, you have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation.
I received very positive feedback on this post and several readers asked me to follow up with some potential planning to mitigate these “creeping” taxes. Today, I will do just that in relation to planning for the tax liability of RRSPs (also some planning not directly related to your RRSP tax liability). Later next month I will follow-up with some planning in respect of corporations “creeping” tax liability. While most of the potential planning considerations relate to those close to or in retirement, there are some considerations for you “young-ins”.
As a quick refresher, spousal RRSPs are contributions typically made by the higher income spouse (contributor) based on their RRSP contribution room (not their spouses), on behalf of their lower income spouse (known as the annuitant). A spousal RRSP made by the higher income spouse will generate the maximum tax refund to the family unit.
Conceptually, by utilizing a spousal RRSP, retirement funds effectively move from a spouse that will be highly taxed in retirement to a spouse that will be taxed at a lower rate in retirement.
It should be noted,that if the annuitant spouse withdraws funds from their spousal RRSP within at least 3 years of a contribution, there is an attribution rule that will require the withdrawal to be added to the contributing spouse’s income in the year of the withdrawal (i.e. – if you made a spousal RRSP contribution in January 2020, your spouse must wait until 2023 before they make a RRSP withdrawal, or else the withdrawal is taxed in your hands). This rule seems to confuse many people; the CRA provides a good example of how this rule works here.
With the introduction of pension income-splitting in 2007, which allows you to transfer up to 50% of your pension income (including RPP, RRSP, RRIF and annuity income amongst other income types) to your spouse or common-law partner, by completing form T1032, many people assume spousal RRSPs have gone the way of the Dodo bird. However, this is not entirely true.
For example, in pre-retirement years, it may be prudent for a low-income spouse to withdraw funds from their spousal RRSP (as long as they do not breach the 3-year rule noted above) if they expect their marginal tax rate in retirement to be higher. This provides maximum planning flexibility. In determining whether the marginal income tax rate savings are worthwhile, you will need to consider the time value of money and inflation versus the actual tax savings.
A further benefit of a spousal RRSP is that a lower income spouse will receive 100% of the funds from their spousal RRSP/RRIF and be eligible to split their spouses RRSP/RRIF. If you do not utilize a spousal RRSP, only 50% of the higher income spouse’s RRSP/RRIF could be split. The spousal RRSP thus provides the maximum income splitting flexibility in retirement.
Similar to a spousal RRSP, it may be beneficial to withdraw funds from your own RRSP in a low income year (say a poor commission year). Or more likely, in the years between retirement and when you have to convert your RRSP to a RRIF (by December 31st of the year you turn 71) if your income is lower and you expect a higher marginal tax rate in retirement.
Prescribed Rate Loan
Where one spouse has significant non-registered assets and pays tax at a high or the highest marginal tax rate and the other spouse has a low marginal tax rate with minimal assets or taxable income, consideration should be given to a prescribed rate loan. See this blog post on the topic. The current prescribed rate is 1% until June 30th, but the rate will very likely increase in the third quarter.
While this tax planning technically has nothing to do with a RRSP, it may reduce the taxable income of the higher spouse such that some of their RRSP/RRIF income is taxed at a lower rate.
If you are between the ages of 65 and 71 with no pension income, you may wish to consider converting a portion of your RRSP into a RRIF and drawing $2,000 per year from the RRIF. This will allow you to claim the $2,000 pension income tax credit. If you do this, you may want to just transfer $14,000 at the outset and take $2,000 per year from age 65-71.
Old Age Security
To the extent you may draw your RRSP down in your early 60’s or take the minimum RRIF amount in your early 70’s, always ensure your planning considers the OAS clawback. The clawback for 2021 starts at $79,845 of net income ($81,761 for 2022). Once the $79,845 limit is exceeded, you will have to repay 15% of the excess over this amount, to a maximum of the total amount of OAS received which is reached at $129,581 of net income.
Tax Efficient Investing
I wrote on this topic in 2017, here are the links to my two blog posts, Part One and Part Two. These posts discuss which type of account (non-registered, registered, TFSA) is the most tax advantageous to hold investments and maximize returns. Investing efficiently may in some cases reduce your ultimate RRSP and thus your “creeping” tax liability, because you increase other more tax efficient sources of income than your RRSP.
Withdrawal Ordering Methodology
While the methodology of your retirement withdrawals will not directly affect your creeping RRSP tax liability, it is part and parcel of minimizing your overall tax burden in retirement.
You, your financial planner, or accountant can generally project what income sources will be included in your income each year in retirement. Those will include CPP, OAS and the minimum RRIF withdrawal amounts and non-registered account interest and dividends and possibly rental income etc. There may be other amounts, but these are the standard income sources. From these amounts you can determine an initial projected pension splitting amount. Once you do this, you will know how much income you will have to cover your yearly cash withdrawal requirements and what your marginal tax rate will be approximately. You then need to plan the most tax effective way to cover any retirement cash shortfalls with other accounts such as non-registered accounts, excess RRIF withdrawals and TFSAs in the most tax effective manner.
So, what is the best ordering methodology? Depends on whom you ask.
Some people suggest that the best way to make withdrawals in pre-retirement and retirement is to take money from the least flexible and least tax efficient source first. This methodology would typically result in you first drawing from your RRSP/RRIF, then your non-registered account and then your TFSA. A somewhat similar suggestion is that you take money from accounts with the highest tax liability at the lowest possible marginal tax rate. Others suggest you keep your RRSP intact and defer the tax as long as possible. Then there are other financial experts who suggest you keep your TFSA intact to provide the utmost in tax-free withdrawal flexibility. Finally, in a recent Globe and Mail article by Frederick Vettese (it is behind a firewall for Globe subscribers only), he suggested it may be best to drawdown from multiple sources rather than trying to keep your RRSP intact (to defer tax) as long as possible.
What these various opinions prove, is that there is not a one size fits all methodology and each person needs to review their circumstances and run various scenarios (with your financial planner or accountant if you have one) to find what is the correct methodology for you.
Looking out at the Grim Reaper – Taxes on Death
The above planning may need to be tweaked when you consider the taxes due on your death. Typically, when the last spouse dies and the balance of their RRIF and the deemed gains on their investments are taxed, it leaves their estate in the highest marginal rate or at a much higher rate than prior to their passing.
Tim Cestnick in another Globe and Mail article (again behind a firewall) suggests it may be more advantageous to bring in more RRIF income (and contribute the excess RRIF income less taxes to your TFSA) over many years at a lower rate, than to defer the tax on your RRIF to your death at the highest or higher marginal rate. Again, you need to review your own particular circumstances (the time value of money will require the tax savings to be large enough to make this worthwhile), but this is something that should be considered.
Much of the planning I discuss above unfortunately requires significant number crunching to achieve the optimal results. This planning can be complicated and requires a huge time commitment. I suggest engaging a financial planner or your accountant to prepare a plan for your retirement, it will be typically money well spent.