Future retirees commonly expect that they will be in a lower tax bracket in retirement as compared to their working years. Invariably this will hold true if the person’s income is lower in retirement and the chosen measuring stick is strictly marginal tax rate (MTR).
A broader measure is a person’s marginal effective tax rate (METR), which includes loss of income-tested benefits. METR can and often does exceed MTR at age 65, and conceivably could be higher than a person’s MTR during working years.
By undertaking a pre-tirement review at age 60, the degree of this impact can be anticipated in time to prescribe steps for mitigating this unwelcome effect.
Tax deferral for retirement plans
The RRSP vehicle offers two key benefits: contributions reduce current taxable income, and investment returns and growth accumulate tax-deferred. The quid pro quo is that all eventual draws are fully taxable, generally issuing out of a RRIF or registered annuity.
In similar fashion under a registered pension plan, employer and employee contributions are pre-tax in working years, and retirement pension payments are fully taxable.
Thus, while the bulk of retirement savings will be well-served through these registered investment plans, income at the margin – the “M” in MTR and METR – may lead to higher tax treatment than planned or desired.
Post-65 benefits and clawbacks
Canada Pension Plan (CPP) full retirement pension is payable at age 65, though it can be elected to commence anywhere between 60 and 70. There is no income test associated with one’s entitlement to a CPP retirement pension.
Also at age 65, Guaranteed Income Supplement (GIS), Old Age Security (OAS) and the federal and provincial age-65 tax credits become available. Unlike the CPP retirement pension, all of these are subject to reductions at prescribed income thresholds, commonly referred to as “clawbacks.”
GIS, which targets poverty relief, has a steep clawback rate of 50% for each dollar of income in its applicable range, and is exhausted well within the lowest federal tax bracket.
OAS is subject to a clawback rate of 15% between income of $67,688 and $110,123 (current at October, 2011). As OAS pension is taxable income, the net after-tax loss is 15% multiplied by the person’s MTR. For example, the net effect for someone at a 33% MTR would add about 10%, to climb to 43%.
For the federal age credit, the clawback rate (also 15%) reduces the base upon which the credit is calculated, with the applicable income range for 2011 being between $32,961 and $75,541. As with most federal credits, the federal age credit is based on the lowest bracket rate of 15%, so the after-tax value of the loss is 15% times 15%, or 2.25%. For provincial age credits, the process operates in a similar manner, with clawback ranges varying and the net after-tax value of the loss ranging between 0.6% and 3.0%.
The following table illustrates the estimated impact of the loss of OAS pension and age credits at selected income levels.
< Table graphics appearing in original not reproduce-able in text>
Prescriptive steps
If a future retiree appears destined to be affected by an unexpectedly high METR, here are some options a financial advisor may wish to raise that could lessen the impact:
- Reduce or forego RRSP contributions, allocating savings instead to a TFSA or possibly even a non-registered account.
- Annuitize a portion of the RRSP, or transfer to a RRIF and commence withdrawals prior to age 65.
- Run ‘what-if’ scenarios for advancing or deferring commencement age for CPP retirement pension to see the effect this might have on METR.
As with prescriptions and treatment in the medical sense, the choices depend on personal characteristics and inclinations. Still, the first step is to diagnose the existence and extent of a problem – and for a 60-year-old looking forward to retirement, that means understanding METRs at age 65.