Category: Blogosphere

Positioning the RRIF minimum reduction

Why this move is so important for affected seniors

On March 30, 2020, the government provided details of the reduction in minimum withdrawals from registered retirement income funds (RRIFs), defined contribution registered pension plans (DC-RPP) and pooled registered pension plans (PRPP).

While all of us are feeling economic stress from this pandemic, things could be particularly problematic for seniors’ saving and spending. Before going into the key measures announced, it’s worth outlining what makes seniors so vulnerable.

General operation of RRIFs

Accumulated savings in a registered retirement savings plan (RRSP) may be taken as a lump sum, used to purchase an annuity that pays a fixed annual amount, or continue to grow tax-sheltered in a RRIF. While this may occur at earlier ages, a RRSP must be matured by the end of the year the annuitant turns 71.

Once in a RRIF, the annuitant/owner is required to take a minimum percentage into taxable income each year. At age 71, the minimum is 5.28%, rising each year until it reaches 20% at age 95 and thereafter.

For RRIFs opened before age 71, it is calculated as: 1 divided by [90 minus age]

Vulnerability of seniors’ savings

Implicitly, the reduction in RRIF minimums is an acknowledgement of the special kind of economic stress many seniors may experience during and following this pandemic. Some of the effects:

  • Despite a senior making efforts to live more frugally or draw from other non/less-taxable reserves, mandatory minimums force RRIF depletion beyond what may be necessary to live on.
  • Funds coming out of a RRIF can’t go back in. That’s a permanent loss of this tax sheltering room.
  • Seniors who are no longer working will have little or no new income as a source for replenishing depleted retirement savings after this episode, unlike those who are able to continue to work.
  • Though the timing is uncertain, an investment market recovery will be expected following this downturn. As a function of age, seniors will have less time to participate in such a recovery.
  • As tax will have applied to RRIF minimums, less net funds will be available to invest in any recovery.
Key measures for RRIF annuitants

The points below are highlighted by the government in the announcement. To reduce the wordiness, only the term RRIF is used here, though again the changes apply similarly to DC-RPPs and PRPPs:

  • The minimum amount that must be withdrawn from RRIFs for the 2020 year is reduced by 25%. For example, the 5.28% minimum at age 71 will be reduced to 3.96%, and at 95 it will be reduced to 15%
  • This measure applies for the 2020 taxation year only, not for future years.
  • For an individual who has already withdrawn more than the reduced 2020 minimum, he/she will not be able to re-contribute to RRIF to bring the withdrawal down to the reduced minimum.
  • The reduced minimum also applies to life income funds and locked-in RRIFs. Such plans have both minimum and maximum withdrawal limits. To be clear, the changes apply to reduce the minimum withdrawal factor, but have no effect on the maximum withdrawal factor.
  • As a general rule, withholding tax is not applied to minimum RRIF withdrawals. The withholding tax rule is unaffected by this special reduction in the 2020 minimum, meaning that withholding tax will continue to apply only to amounts above the unreduced minimum for the year.

Basic Personal Amount – Will BPA changes truly provide tax relief

The federal government recently put a key piece of their tax platform in place: an increase in the basic personal amount (BPA). This is expected to lower taxes for close to 20 million of us, and eliminate any federal tax liability for almost 1.1 million Canadians.

To deliver on this promise, the government will increase the BPA to $15,000 by 2023. On the face of it, that’s a nice, round, substantial figure, and no doubt many of us will experience tax savings. Still, to give it some proportionality and context, let’s take a closer look to understand how, when, to whom, and to what extent this will provide tax relief.

DEDUCTIONS AND CREDITS

Most non-tax professionals likely don’t pay too much attention to the difference between a tax deduction and a tax credit. Both can reduce a person’s tax bill, but in a very real sense they are applied at opposite ends of the income spectrum.

A deduction reduces the amount on which tax is calculated. Because we have a progressive personal tax system (i.e., higher rates applying to income at higher brackets), a deduction reduces tax exposure at a person’s uppermost or marginal rate.

In terms of tax credits, a non-refundable credit reduces your initially calculated tax due, whereas a refundable credit is more like a subsidy in that it is paid even if you don’t owe tax. In either case, a maximum amount is legislated for a given purpose, against which the appropriate credit rate is applied. With a few exceptions (mainly charitable and political donations), the credit rate most often is at the lowest bracket rate. For federal tax calculations the lowest rate is 15%, but a person’s own income dictates the marginal rate, which may be as much as 33%.

Connecting those dots, a deduction is generally more valuable than a credit.

The most common non-refundable credit is the basic personal amount, sometimes called the basic personal credit.

Either way, it’s referring to the same thing — effectively negating tax on income from zero up to the set level. For instance, when you file your upcoming return for the 2019 taxation year, you’ll claim this credit on your first $12,069 income. At the 15% rate, the value of the credit is $1,810.

While it may seem an obvious point, note that the amount is larger than the credit value, since it is multiplied by the credit rate. Keep this in mind as we turn our attention to the change in the amount, and contemplate the value of that change.

ENHANCED BPA

Over the course of the next four years, the BPA will be bumped beyond its usual inflation indexing until it reaches $15,000 in 2023. The rollout schedule is shown in the first three columns of the table here, reproduced from the Department of Finance backgrounder. The two right-hand columns are my own calculations for the sake of some analysis to follow.

The additional BPA will initially yield $140 in annual tax savings, rising to about $300 in 2023, as featured in official communications. In that last year, the $15,000 amount will equate to a full value for the BPA of $2,250, a 13% improvement over what current indexing would have given.

However, it will be almost four years until early 2024 tax filing when that extra $300 may be claimed. Using the approximate 2% indexing employed by the Department of Finance, that discounts back to about $277 in current dollar value.

To be clear, I’m critiquing, not criticizing; my aim is to couch expectations of the practical implications for individual and household budgets. That last point is especially important, as there are parallel changes to the spousal and eligible dependant amounts, the effect of which will be to double the impact to as much as $600 for families claiming either of those credits.

INCOME CEILING AND TIME HORIZON

Not everyone will enjoy this enhanced BPA. Extra components will be added to the BPA definition to reduce the enhancement as income enters the 29% fourth bracket, until it is eliminated for someone whose income exceeds the 33% top/fifth bracket. For 2020, those thresholds are $150,473 and $214,368. For your curiosity, a $300 loss across this range is a clawback contribution to a marginal effective tax rate of just under 0.5%.

The BPA and brackets will continue to increase each year according to the existing indexation formula, but the BPA enhancement will remain at $15,000 after 2023. This means that the value of the enhancement will continually erode each year thereafter. Using that 2% index factor as a proxy, the BPA would overtake the enhancement by about 2030. Whether this will still be a feature of our tax system a decade from now is anyone’s guess.

3 thoughts on establishing your emergency fund

Published version: Linkedin

For a long time, we didn’t have an emergency fund, though we’ve had a line of credit (LOC) for quite a while.

Our household budget was within our means. We were operating fine in our regular spending routine without having to check when payday was coming. There was also a fair amount of reserve that had built up in the separate accounts we’d established for each of the major expenses.

It wasn’t for fear of holding money in no/low-interest cash that might otherwise be making investment income. No, that’s exactly the effect of those individual accounts anyway. Rather, we were confident in the arithmetic, and didn’t think there was a need to have that one account.

It wasn’t until we had to dip into one of those reserves to replace an appliance that our perspective shifted: Large though that reserve had become, it had a defined purpose and calculated amount that would eventually deplete it. Emergencies aren’t like that.

1. The why of an emergency fund

An emergency fund isn’t about being budget-conscious; it’s about potentially being UNconscious, indisposed and/or impecunious at a time when there remains a budget to be serviced. It’s about you and your ability to be the continuing funding source for your household.

It’s also about being able to respond to large, unexpected expenses. Be careful though not to confuse that with the major expense reserves mentioned above. Years will pass before those needs may arise, but while the exact timing may be unexpected, those remain inevitable.

At the other extreme from normal budgeting are unlikely things such as catastrophic property damage, permanent disability or death. Insurance is for those remote-risk/high-peril events. Between those two is where an emergency fund is situated.

2. LOC or emergency fund – What’s your gut feel?

Part of my own early confidence lay in the fact that as the mortgage was being knocked down, we’d set up a substantial line of credit. It was more than sufficient for the 3 months – or even 6 or 12 months – worth of accessible funds variously suggested to bridge until things would be expected to normalize after an emergency might hit.

But over time I became more familiar with my own emotional relationship with money. Ever since I had a mortgage … I didn’t want one anymore. Though we lived contently and made appropriate allocations to retirement and children’s education savings, the extra dollars were put toward trimming that large liability. That was the mindset and routine while in the midst of stable finance and balanced emotion.

So, how might I feel in a future time of monetary and mental stress, being compelled to dive deeper into debt? Not good in all likelihood. In fact, that prospect could easily exacerbate the impact of any emergency that may in fact arise, and extend out the recovery time. For us, that was when the formal emergency fund took shape, while maintaining the line of credit as the next line of defence.

That’s our family, not necessarily yours. Still, you would do your future-self a great favour by taking the time while things are rosy to contemplate how you will feel when things are not.

3. Deciding your __ months of money?

Assuming you’re committed to the purpose, the first action question to address is how much will you accumulate in that fund? The commonly suggested proxy is, as mentioned above, a certain number of months’ worth of accessible funds. But how many for you: 3, 6, 12, more?

As the timing and extent of an emergency is unknown, there is no formula to provide you with a definitive number. A practical approach is to focus on the most likely of those unlikely events: an employment gap, whether of your own choice or initiated by your employer. Knowing yourself and the industry where you work, how long do you think it would take to get re-situated? Other factors will come into play, like severance pay and employment insurance, but start here as a rough target.

Second, be clear about what this number of months means. In theory it is lost income, but more importantly in an emergency situation, it is the amount of spending that has to be replaced. The two are connected, but the latter continues even in the absence of the former.

Fortunately, unless you’ve been living excessively, your spending will be less than your earnings. Look back at your bank and credit statements over the last year. Take out the truly extraordinary things, and deduct items you can suspend or defer, at least in the short term. This is the monthly average to multiply by your chosen number of months to give you a target.

Third, how much will you regularly deposit into your emergency fund? By “regularly”, I mean weekly or in alignment with your pay cycle, which brings us back to your budgeting. As remote as an emergency may be, you need to assign a percentage or dollar amount that you can commit to, even if that’s a small figure.

Here then is another gut check: Divide your accumulation target by your weekly deposit commitment to tell you how long it will take to get there. If you’re feeling a knot forming in your abdomen, you may want to bump your commitment. Balance that against the discomfort of the current budgetary sacrifice to arrive at a manageable medium.

With a line of credit at your back along the way, you now have a process, timeline and dollar target to get your own emergency fund in place.