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How early withdrawals can reduce the RRSP tax hit

Toronto, Ont. October 20, 2009 - Garth Turner, former MP, financial journalist and author of Greater Fool: The Troubled Future of Real Estate. For Let's Talk Investing with Rob Carrick. (Photo by Anne-Marie Jackson/ The Globe and Mail)

Anne-Marie Jackson/The Globe and Mail

Retirees younger than 71 often believe they should allow their RRSPs to accumulate while they live off their non-registered investments. But after more than 20 years of putting together retirement-income strategies for his clients, financial planner Daryl Diamond maintains that the biggest payoff can come from tax savings.

These retirees don't realize that the benefits of tax-free compounding can be undermined by higher tax brackets and clawbacks. This is especially true following an RRSP's conversion to a registered retirement income fund (RRIF) at age 71.

A person in a lower tax bracket than the one they will face in future years (after income splitting) should consider removing funds from their registered retirement savings plan until income rises to the ceiling of the tax bracket just under the one they'll be in, says Mr. Diamond, who is founder of Winnipeg-based Diamond Retirement Planning Ltd. and author of Your Retirement Income Blueprint. Tax will be paid on the withdrawals, but it will be less than what would be paid down the road.

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Jean Lesperance, the blogger at Canadian Financial DIY and HowToInvestOnline, is gradually "melting down" his RRSP in support of a semi-retired lifestyle. Still a few years younger than 65, he is also funnelling RRSP withdrawals into his tax-free savings account (TFSA) to have the flexibility to receive tax-free income that can augment or replace RRIF withdrawals later.

"That's to keep me in the lowest possible tax bracket all along, and to minimize as much as possible the clawback of income from government programs such as OAS [Old Age Security]" Mr. Lesperance says. "If I can pay 20 per cent tax on $50,000 RRSP money instead of 30 per cent tax, that's like a 10-per-cent return on my money. Taxes matter a lot."

He likes TFSAs for other reasons. They can pass entirely as a legacy to his heirs, in contrast to what's left over after the highest marginal tax rates are applied to a major portion of an RRSP or RRIF that's collapsed at death.

Marie Engen is co-author of the Boomer & Echo blog and also a few years younger than 65. She is looking into the best way to withdraw from her RRSP in the next few years without incurring too much tax. "I'm thinking of doing 'in kind' transfers to my TFSA of my good dividend-paying stocks and using the dividend withdrawals for income," she says.

Investors can also transfer stocks to a non-registered account at a brokerage, where dividend income and capital gains will be taxed at preferential rates. (However, U.S. dividend stocks might be kept in the RRSP, where they escape U.S. withholding taxes.) Another place to stash RRSP withdrawals is in corporate class mutual funds, Mr. Diamond suggests. Among the advantages: switches within the fund family don't trigger capital gains, interest income is almost exclusively treated as capital gains, and monthly withdrawals under the "T-series option" are deemed return of capital (until the adjusted cost base, or ACB, falls to zero, at which point the distributions are taxed as capital gains).

Low-income seniors with RRSPs may want to melt them down before 65 no matter what their tax rate is. It is unlikely to be as high as the clawback of the guaranteed income supplement (GIS): a dollar of RRSP income after age 65 snatches back 50 cents from the GIS, equivalent to a 50-per-cent tax rate.

Middle-income seniors can receive close to $20,000 in annual income tax-free thanks to the basic-personal, age, and pension-income tax credits on their tax returns (Lines 300, 301 and 314). If nondiscretionary retirement income (e.g. OAS, corporate pension) is less than this amount, the difference can effectively be withdrawn from RRSPs free of tax.

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Retirees shouldn't wait until 71 to open RRIFs and transfer in RRSP funds, advises Ron Watson, 68, of Thunder Bay, who gives workshops on entrepreneurship and financial management. RRSP withdrawals are subject to transaction fees and tax withholding, whereas RRIF withdrawals are subject to withholding only if withdrawals exceed the investor's "minimum" annual amount. Moreover, after 65, RRIF withdrawals are eligible for income splitting, and the pension income tax credit can be applied to the first $2,000 taken out every year.

An aggressive form of the meltdown relies on leverage to extract RRSP funds without incurring any or very much tax. It works this way: RRSP withdrawals are used to pay, in full or part, the interest on an investment loan in a non-registered account. Since the interest is tax deductible, it cancels out the taxes on RRSP withdrawals, in full or part.

A leading proponent is Garth Turner, the former member of parliament who blogs at "I plan to borrow a mess of money to invest in a nice, balanced portfolio, then use RRSP withdrawals to pay the interest on that investment loan. ... By the time 71 rolls around, the net effect is that I'll have transferred wealth from one pre-tax pile to another after-tax one."

An earlier online version of this story and the original newspaper version incorrectly stated that RRIF withdrawals are not subject to tax withholding. This online version has been corrected.

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