Everyone loves the immediate tax benefit of contributing to an RRSP. The contribution is used to reduce your taxable income, saving you tax at your marginal tax rate.
Marginal tax rates in Manitoba for 2013 are 34.75 per cent for taxable incomes between $43,000 and $67,000, moving up to 39.4 per cent between $67,000 and $87,000 taxable income, 43.4 per cent up to $135,000, and 46.4 per cent on taxable incomes above that figure. For example, a $10,000 contribution by a person with taxable income of $60,000 will reduce that person's taxes by $3,500, assuming they have qualifying RRSP contribution room.
Whoops... Did I say tax saving? I should've said tax deferral because those saved taxes will have to be paid one day.
Best-case scenario for an RRSP is that the person contributes when in a high tax bracket, say, while working full-time, and then withdraws later, in a low-income year when taxed at a lower tax rate. Therefore, the basic strategy is to plan RRSP (or RRIF) withdrawals using two fundamentals -- as low a tax rate as possible and maximum deferral.
All things being equal, deferring is a good thing. If you can earn investment income on the larger pre-tax amount of your RRSP or RRIF and delay the taxes as long as possible, you will have more principal value. Even if you pay more dollars of tax on withdrawal, you will still have more left over to spend, after paying the taxes.
Assuming you have other sources of income in retirement, my philosophy is that you might choose to defer some of this tax until after you die. If you leave this to a surviving spouse, the money transfers tax-free into their RRSP or RRIF. If you die without a spouse, then the entire amount of your plan is taxed to your estate in the year of death.
The counter argument is that you might have been able to withdraw money paying tax at 35 per cent, while your estate might pay it at 46.4 per cent. Given the option, I might still choose door No. 2. (Sorry kids.)
This brings us to the more important dilemma: Do I pay tax early in retirement at, say 35 per cent, or do I wait until age 71, when CRA will force me to convert all of my RRSP into RRIF, and make taxable withdrawals?
The answer is: It depends.
We prepare an annual calculation for our clients to confirm our chosen strategy each year, but here are guidelines you can use.
First, the RRIF rules. At 71, the minimum required withdrawal rate is 7.38 per cent. That means a $100,000 RRIF will require a taxable withdrawal of $7,380 in the following year. That amount could be quite manageable, without bumping into the next tax bracket or causing OAS clawback.
However, for people with larger RRSPs, the dilemma is more profound. With $500,000, the required withdrawal in your 72nd year is almost $40,000. Some of that money will certainly be taxed at the next higher tax bracket, and possibly even 15 per cent more.
That 15 per cent is the rate of clawback on OAS benefits, once net income exceeds $70,954. For every dollar of taxable income above that figure, anyone 65 or better is taxed at 39.4 per cent or more, plus 15 cents withheld from every dollar of OAS, an effective tax rate of over 54 per cent. That should be avoided.
So, a person who is retired at 60 might be better off withdrawing some amounts from their RRSP then, if taxable at 27.75 per cent, in order to decrease future withdrawals taxed at twice that rate. Employer pension income, pension-splitting opportunities, tax-paid resources like TFSAs or non-registered investments enter into the picture.
For more reading, I suggest Your Retirement Income Blueprint, by Daryl Diamond, or my book.
Now, have a great weekend at the 40th anniversary Winnipeg Folk Festival -- and don't worry about this stuff until Monday!
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner, adviser and vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.