Contributing as much as possible to your RRSP has typically been considered the best way to plan for retirement. But, when you consider after-tax income, there might be times when cashing out part of your RSP can increase your after-tax cash flow, reduce future taxes and help ensure that you qualify for Old Age Security (OAS) payments.
RRSP contributions offer two main benefits: 1) Tax deferred growth: money invested in RRSPs grows tax-free until the money is drawn down, typically when converted into a RRIF – after age 71. 2) Income tax arbitrage: Since the RRSP contributions are fully tax deductible and the RRSP withdrawals are fully taxable, investors are able to significantly reduce their taxes by contributing to RRSPs in their working years when incomes and marginal tax rates are higher and then pay income tax at a lesser rate when withdrawing from an RRSP or RRIF in retirement. For example, a 45 year old earning $110,000 a year is able to reduce her taxes by 43.4% for every dollar contributed to her RRSP, but if her income in retirement is $60,000, she will be paying tax at 31.2%, a net after-tax benefit of over $0.12 on every dollar. But, there are opportunities where income tax arbitrage favours withdrawing funds from an RRSP. Two examples are illustrated below.
Wealthy Widow / Widower
Linda and Frank provide a good example of the potential after-tax benefits of RRSP withdrawals for widows (and widowers). Linda and Frank were married for 35 years. Both had worked most of their lives, and neither was entitled to a pension other than the Canadian Pension Plan (CPP). Both had also amassed RSPs of over $500,000 each. Frank recently passed away and Lisa at age 66 decided to retire.
Lisa’s income, which had been $100,000/yr., suddenly declined to about $20,000 in retirement. Her marginal tax rate dropped from over 43% to just 20%, but her RRSP, which was now combined with her husband’s, increased to over $1,000,000. If she chooses to begin withdrawing money from her RRSP at age 66, when her tax rate is substantially lower versus waiting until age 71 to begin her RRIF, she could save substantial after-tax dollars and significantly reduce her OAS clawback.
Assuming, modest 4% growth per year, Lisa’s RSP will be worth over $1,300,000 by the time it is converted to a RRIF and she begins her withdrawals at age 72. Since the minimum withdrawal rate at age 72 is 7.48%, she will be required to withdraw over $95,000 per year, bringing her total income to well over $110,000 when including CPP payments and small cash investments. She will have to pay over $30,000 of that money back to the government each year in taxes AND likely forgo over $6,000 per year in OAS payments as they begin being clawed back with incomes above $70,954.
If Lisa instead took out approximately $50,000 per year from her RSP from age 66 -72 she and her estate would save over $145,000 in taxes and reduce OAS clawbacks by over $55,000 (assuming that she lives until age 85). This is a net benefit to her and her estate of over $200,000 in after-tax dollars.
High Income Earning Spouse
RRSP withdrawals can also be highly beneficial for couples where one spouse earns substantially more than the other, providing over $11,000 in after-tax income in the example below.
Jeff and Sarah are a couple in their early 40s. Sarah, a graphic designer, decided to work part-time to be home more often with her kids. Jeff, a lawyer, earns $170,000 per year. Sarah earns $30,000. Jeff spends most of his salary to cover family costs, so he has over $50,000 of RRSP contribution room remaining and is rarely able to max out his contributions. Sarah has an RRSP of $50,000.
If Sarah cashes out $20,000 from her RRSP in year 1, $20,000 in year 2 and $10,000 in year 3 and Jeff uses those same funds to make his own RRSP contributions, the couple could save $11,420. The reason the benefit is so large is that Jeff pays tax at the marginal tax rate of 46.4%, so each $1,000 contributed to an RRSP provides an after-tax benefit of $464. Sarah’s average tax rate on the withdrawal would be 24.4% or a cost of $244 for every $1,000 withdrawal. Therefore, every $1,000 that Jeff contributes to his RRSP and Sarah takes out from hers provides a net after-tax benefit of over $220. The strategy makes most sense for couples where one spouse earns substantially more than the other, that spouse has a large amount of RRSP room remaining and he/she is unlikely to use that room for many years. There will be withholding tax charged on Sarah’s RSP withdrawals, which can be claimed back when she files her tax return.
Spousal RRSP plans are a further way of utilizing this same strategy to increase a family’s after-tax income. Jeff is able to take a full tax write-off for every dollar contributed to a spousal RRSP. But after three years, any withdrawals from a Spousal RRSP will be attributed from a tax perspective to Sarah. Consequently, by Jeff contributing $20,000 a year to a Spousal RRSP for Sarah and then Sarah withdrawing that same sum at least 3 years later, the couple can increase their after-tax cash flow by $4,400 per year.
Taking funds out of RRSPs during years where earnings have declined substantially, e.g. if you decided to take a prolonged vacation or sabbatical, or if you are out of work for an extended period of time, may be another way of benefitting from income arbitrage.
RRSPs are a great way for investors to save for retirement, but there are occasions as described above where partially cashing them out can increase overall client wealth. During the financial planning process, our objective is to ensure that each client’s retirement goals are met by focusing on the appropriate investment mix and by using the most effective strategies available to increase after-tax cash flow and the value for their estates.
To find out more about this and other tax effective investing and planning strategies, please contact Lorne Zeiler at 416-733-3292 x 225 or by e-mail at lorne@tridelta.ca.
Lorne Zeiler, MBA, CFA
VP, Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225
