Its been interesting to observe the number of people who are choosing to retire early as we work our way out of the pandemic as opposed to returning to work. I think Covid has caused everyone to reflect on their lives and make decisions they otherwise would have deferred. One example, are our clients in their mid fifties, who sold their city house and moved to their cottage. They have positioned themselves for an early retirement and are still working remotely while they contemplate pulling their career plugs.
But for many, investing for retirement isn’t easy. But it can pale in comparison to dealing with investments once you have reached the magic date. Not only do retirees still have to manage their money, they must ensure they don’t outlive it as well. They have to draw income, too, often from multiple sources, each with its own tax and other financial implications. Take too much from one source at an ill-advised time and you could harm the longevity of your savings.
Tax mitigation of retirement assets
A retirement portfolio should be structured to pay the least amount of tax as possible legally allowed. Developing a strategy can be challenging because most retirees draw income from multiple sources, such as the Canada Pension Plan (CPP), Old Age Security (OAS), registered retirement savings plan (RRSP) and sometimes a work pension. Moreover, many also have a tax-free savings account (TFSA), one or more locked-in retirement accounts (LIRAs) and non-registered savings in taxable accounts.
Each account may be subject to different levels of taxation, and, consequently, where you hold investments such as stocks, bonds, mutual funds, segregated funds, and guaranteed investment certificates (GICs) becomes all the more important.
It’s an asset-location approach. Withdrawals from registered accounts, including RRSPs, RRIFs (registered retirement income funds), LIRAs and LIFs (life income funds) are fully taxable income. Like work pensions, income from RRIFs and LIFs can be split with a spouse to reduce taxation once plan holders reach 65.
But whether income from registered savings is split or not, many investors hold interest-earning investments in these accounts because interest is fully taxable, so no advantage is gained or lost. Other investments, however, offer more advantages when held outside a registered account.
Typically, that includes Canadian equities, because just 50 per cent of a capital gain realized on them is taxable (although the federal government is currently toying with the thought of raising the percentage of taxable capital gain inclusion to 75%.) Effectively, the taxes owing on capital gains are half of those on earned and interest income. In addition, qualifying dividend income from stocks and equity-based funds generates a tax credit that reduces taxes on dividends.
Taxability of TFSAs
Another increasingly important consideration is how TFSAs fit into the picture. In general, we encourage people to think of drawing income from the TFSA as the last source of potential retirement income. The TFSA is a safety net or buffer for both income or capital needs.
Because TFSA withdrawals are not subject to taxation, these accounts function as ideal slush funds for home renovations, major vacations and emergencies. Given the TFSA’s tax-free nature, many experts recommend holding interest-earning investments in them. Anything that does not have preferential tax treatment should be held in the TFSA first.
Another school of thought suggests retirees hold growth investments in a TFSA, too, given interest rates are at historic lows and tax savings on interest within TFSAs may not be substantial now. Equities can offer more tax efficiency because they have the potential to grow much more in value over a longer time, providing, for example, a significant tax-free asset for the estate.
Retirees are best off not holding US equities inside a TFSA, however, because dividends are not eligible for a credit for the withholding US tax as they are when held in a non-registered, taxable account. Retirees wanting to invest in foreign equities in a TFSA can invest in TSX listed ETFs or mutual funds that hold foreign securities. Another option is holding US securities inside registered retirement accounts where a tax treaty exempts them from US taxation.
Retirement asset draw down
Equally important for retirees is developing a plan to draw income using a two-pronged approach. The first is to determine how much after-tax income you need to cover both your basic living expenses as well as your lifestyle expenses. The second, the top down approach means figuring out the amount of income received from different sources of income: work pensions, CPP, OAS and investments. The objective is to compare the two results to see to what extent they are in alignment.
If guaranteed income sources such as work pension, CPP and OAS are sufficient for basic living costs, the next step is determining how to draw income for lifestyle needs from savings. Many retirees are inclined to not draw from registered accounts like the RRSP early in retirement to avoid paying more taxes than necessary. Instead they look to other sources.
Yet it may be better to do the opposite: systematically withdraw from registered accounts to slowly grind them down with the goal of paying a lower tax rate over time instead of waiting until age 71, when mandatory withdrawals begin limiting the ability to control taxation on income.
Delaying paying taxes as long as possible is generally a good thing, but you don’t want to do it so you pay more taxes in the long run. Leaving registered money intact as long as possible can also lead to OAS payments being clawed back.
But taxation during retirement is not the only consideration. Many retirees need to be mindful of the tax bill once they’re gone, because the value of registered money is reported as income on the final tax return if there is no surviving spouse. And CRA’s cut could be almost half of its value.
When you factor that into the equation, the order in which you’re going to draw your money from investments often changes. Yet the starting point should always be income needs. It dictates the investment strategy not the other way around.
The bottomline
The approach outlined above will then tell you more about the kind of investments you should own, the amount of risk you should take and where to draw from at each stage of retirement. Odds are if the income strategy is secure and tax efficient, you do not need to take much risk in the portfolio. The concept as you approach retirement should be preservation of your assets given you are past, or should be past, the accumulation stage.
Where to hold certain retirement assets, the types of investments you should hold and your risk tolerance should be top of mind as you approach retirement. Once you are retired, it is likely that you will move into drawing income and the appropriate approach should be to mitigate the amount, and the tax implications, depending on your lifestyle choices. We actively are monitoring client portfolios as they approach retirement with detailed draw down strategies contained in their financial life plans. Preparation and pre-planning are inherent to Keeping Life Current.
