Tag: RRIF

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  • The minimum amount that must be withdrawn from RRIFs for the 2020 year is reduced by 25%.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.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.