Death and taxes…the happy link between them is a long, tax-efficient retirement. Average life expectancy at birth in Canada is 81, so if you retire at 60, you’ll need to fund just over 20 years of life. Planning through a tax lens maximizes two precious resources: time and money.
Like managing your health, managing tax risk is a lifelong affair. Two rules can extend the longevity of your money: first, stay focused on tax-efficient accumulation and growth in pre-retirement; then vigilantly shelter capital from tax with accurate, tax-efficient withdrawal and transition strategies.
Investing in the right “tax buckets” increases what you accumulate and how fast it grows. Conventional wisdom is to take every opportunity to reduce and defer taxation to maximize the time value of money. In retirement, in order to maximize income while preserving capital, you’ll want to layer in taxable income sources over the longest possible time, “averaging down” tax. You gain more ground splitting income and capital with family members. Plan around three life events: pre-retirement, phased-in retirement from 55 to 70, then full retirement after age 70.
Pre-retirement: There are three non-negotiables in this stage. First off, you’ll be building up contributions to the Canada Pension Plan (CPP). This contribution-based, indexed pension is mandatory, so it’s a great thing for people who aren’t able to save much.
You also want to consider saving in a Tax-Free Savings Account (TFSA). Anyone who is 18, or older, and a resident of Canada can make annual $5,500 contributions, providing a tax-free retirement down the road!
If offered, try to join a private pension plan. Registered Pension Plans (RPPs) come with many benefits: employers contribute principal, you get tax deductions for your contributions, and earnings grow tax-deferred. Later, you qualify for pension income-splitting, with no age restrictions. That’s a big advantage over the RRSP-only saver.
If you have no employer pension, take advantage of RRSPs. You get a tax deduction if you have qualifying contribution room; that lets you reduce income tax, increase tax credits and grow returns on investments by deferring tax on earnings. Future withdrawals from RRSPs will be taxable, but can be income-split with a spouse at age 65. Contribute to a spousal RRSP to income-split sooner. You can also withdraw limited amounts tax-free to fund a home purchase or lifelong learning.
Phased-in retirement. If you’re 55 and a member of a defined-benefit (DB) pension plan, you may be able to work part time and receive a pro-rated portion of your salary and pension. Qualifying employees can draw up to 60% of the benefits accrued while working part time and earn pension benefits based on current employment. You come out ahead by income-splitting sooner with your spouse.
Between age 60 and 70: Gain tax efficiency by maximizing tax-free zones: creating income to the top of your tax bracket reduces taxes and clawbacks. We all get the federal Basic Personal Amount: $11,038 in 2013. The Age Amount of $6,854 starts at 65 for net incomes under $34,562. The tax-free zone is almost $18,000; for couples, $36,000 if each spouse is 65.
Federally, the lowest tax bracket ends at $43,561; the next ends at $87,123, then $135,054. If you earn $35,000 in taxable income, withdraw an extra $8,500 from RRSPs to be taxed at the lowest marginal tax rate despite a small Age Credit clawback.
You must convert RRSPs to life annuities or RRIFs by 72, but it may be more tax-efficient to do this sooner. Creating RRSP/RRIF taxable income from age 60 to 86 provides 26 years to average down taxes; wait until 71 and it’s only 15 years. Why risk paying more in tax or having social benefits clawed back? Instead, average in smaller taxable income amounts sooner over a longer time.
This works well because of public pension reforms. If you work, you must pay into CPP until 70; contributions are optional between 65 and 70, if you work and receive benefits. Postponement raises benefits and frees up 10 years to report other income sources. As of July, retirees can postpone taking OAS till age 70, a good option if you are subject to a clawback for net income above $70,954.
Pension postponement won’t make sense if life expectancy is lower. If your health isn’t good, it’s best to create larger pensions sooner, paying the tax and spending more to maximize your lifestyle.
After age 70: The tax focus is capital preservation and avoiding high-income brackets. This is important for single, widowed, separated or divorced taxpayers, who must add untaxed RRSP and RRIF accumulations to income in year of death. In some provinces, tax rates approach 50% on incomes between $100,000 and $500,000. Retirement income averaging will pay off especially well for your heirs. M
Evelyn Jacks is president of Knowledge Bureau, which offers e-learning at www.knowledgebureau.com. Evelyn tweets @evelynjacks and blogs at evelynjacks.com.