A few weeks ago I was talking to my retired friend Adrian over breakfast. Adrian’s my kind of person – a chronic saver. He’s done pretty well for himself over the years, and saved up quite the retirement pool of money. Adrian’s always been a low-lifestyle kind of guy, and that’s continued into his retirement. I once offered to take him to lunch, and he agreed on the condition that it “wasn’t a fancy place”, as he was a “plain and simple kind of guy”. Once, for a special occasion I had taken him out to a steakhouse as a treat. He’d nearly had a heart attack looking at the menu, claiming it was way too expensive. I gently reminded him that I was paying, and pointed out that $30 for a steak dinner was hardly unreasonable in the city. I found out later in the meal that he was used to the $15 steak at his favourite country kitchen, but this one “was really tasty, especially since it was free”. I chuckled to myself. Adrian was prone to gestures of tremendous generosity to his friends and wouldn’t have hesitated to buy me a much fancier dinner had the tables been turned. He couldn’t, however, bring himself to stomach his friends spending money on him. Small wonder that his friends, myself included, are so fond of him!
When Adrian and I spoke last, he was in a tizzy. Adrian’s been a self-managed investor his whole life. He’s justifiably proud of his nest egg, which has grown nicely over the years. Adrian had gone his entire working life maximizing his available RRSP room, which accounts for the vast majority of his savings. There are relatively few people who aren’t professionals who are as adept as Adrian was at running his own investments. It was a passion in his working years, and his hobby since retirement.
Unfortunately, Adrian just realized that his chronic saving plans may have backfired. He’s started realizing that when he turns 72, he has to take out 5.25% out of the balance of his RRIF – and that amount will only get higher as he ages. The kicker is that he has to take the money out whether he needs it or not – and with his very modest lifestyle, he really doesn’t need to draw the funds out at this point in time. The extra funds are going to bump up Adrian’s tax-bracket too, AND he’s going to lose some of his Old Age Security (OAS payments), at a rate of 15 cents on each dollar he earns over $81,761.
Adrian’s wife passed away a few years ago, and Adrian inherited her government pension plan, and her RRSPs. As a result, his income needs are more than covered. Before she died, they were able to keep below the OAS clawback threshold by income splitting, but now that all of the income is in his name, he’s right at the margin. His “forced” RRIF withdrawals will be the tipping point to push him into clawback. On top of it, if Adrian dies today, Adrian’s estate is going to have to pay a whack load of tax on all those savings. Adrian’s mad as heck to lose out. “You better tell everyone about this in your next newsletter” were his parting words to me. Who am I to argue?
Don’t get caught in the trap that Adrian did
In the short term, RRSP savings are incredibly attractive. Combine an up-front tax break, with many decades of tax deferral, and disciplined savers can find themselves with a nice balance in their registered accounts. There’s a few downsides though to putting all your eggs in one basket:
- Lump sum withdrawals from your RRSP or RRIF can be costly. Any amount withdrawn will be subject to inclusion in your income, resulting in more tax. If you are in a 30% tax bracket, and need $20,000 to get a car, you’re going to have to take out $28,571 of your RRSP to net $20,000. If your tax bracket is 40%, you’d need to withdraw $33,333. To make things more complicated, most of the time your RRSP/RRIF provider will need to withhold tax at source – up to 30%, which may or may not match your marginal tax rate, leading to surprises come April when you file your tax return.
- Tax on your estate will jump HUGE from your RRIFs and RRSPs. When you die, you have to include the full value of your RRIF or RRSP accounts into your income – which can easily put you in the top marginal tax bracket (53.5% in Ontario). If you have a spouse, you can defer this until their passing, but eventually, CRA has to get paid the tax. This is perhaps the single biggest discussion point when I’m doing financial planning work.
- They can look great – until you lose your partner. As Adrian discovered, you can income split while both you and your spouse are alive, but once all the RRSPs & RRIFs are in one name, your income can jump dramatically.
So how can we avoid Adrian’s situation?
Clearly there are distinct advantages to RRSPs/RRIFs, even with the downsides I’ve listed above. Here’s just a few ways you can limit your RRSP/RRIF problems:
- Maximize your TFSA room before making RRSP contributions, especially when you have significant savings in your RRSPs already. While TFSAs don’t give you up-front tax relief, they may be a superior choice in the long term. Lump sum withdrawals are tax free, withdrawals don’t count against OAS for clawback, and they generate no tax on your estate.
- If you retire early, spend down your RRSP/RRIF funds first over other sources. If you can keep the balance down by the time you are 72, you will be less affected by OAS clawbacks on mandatory withdrawals later on.
- If you make some larger donations, use the resulting tax credits to drain funds out of your RRSP/RRIF. This won’t solve OAS clawbacks in the year you donate (as you’d have high income), but may later on.
- See if making one large lump sum withdrawal in one year makes more tax sense than spreading it out over several years. This seems counterintuitive, but if you are already losing all your OAS to clawbacks, sometimes the math works out better to take more, since there’s no more OAS to lose that year.
- If you’ve already accumulated a pile in those accounts, do some smart estate planning and set up a life insurance policy to pay for the taxes. Often the insurance is vastly less expensive than the estate paying the tax out of pocket.
- Name a charity as beneficiary on your RRSP or RRIF accounts – usually, for most estates, the tax owing on the RRSP or RRIF will almost exactly match the charitable tax credits generated by the donation.
One last important point
Adrian has managed his investments on his own, and he’s done very well for himself – but as he’s learned recently, investment selection is only a small part of the financial planning you need to do when looking at the big picture of your wealth. The best time to start bringing in a professional – even for self-managed investors like Adrian – is much earlier than you might think. Had Adrian had a conversation with a financial planner in his 40’s, or even his 50’s, he likely would have saved differently and be in a better spot overall today. Still, there’s lots we can do to help Adrian now that he realizes he has a problem. Hopefully, thanks to Adrian insisting I write this article, you can get started sooner on your own planning needs.
Contact us today for a free consultation or check out Driven by Purpose, a book written by Ryan Fraser, which shows you the possibilities for growing your wealth and making a real impact through the legacy you plan to leave. The book features real, personal stories and offers dozens of strategies for leaving a lasting legacy.
The information provided is accurate to the best of our knowledge as of the date of publication, but rules and interpretations may change. This information is general in nature, and is intended for informational purposes only. For specific situations you should consult the appropriate legal, accounting or tax advisor.