As the year end approaches, Canadians who celebrated their 71st during the year are likely in discussion with their advisor or custodian about the mandatory conversion of their Registered Retirement Savings Plan (RRSP) to a Registered Retirement Income Fund (RRIF). The exercise can be an intimidating one for those whose talents and interests lie outside the financial arena, but the event is really quite straightforward.
Over the years, your RRSP grew progressively larger as you made contributions and the investments grew and generated income. All growth and income within the account was tax free and the contributions you made reduced your taxable income in the year it was made, lowering your taxes. The design of RRSPs — tax free growth and income-reducing contributions — is very much purposeful: to encourage retirement saving.
But all good things must come to an end. Canada Revenue Agency (CRA) rules dictate that by the end of the year in which you turn 71, you must convert your RRSP to a RRIF. As with the RRSP, investments held within the RRIF continue to grow and generate tax-free returns. However, your new RRIF now has a CRA-mandated withdrawal rate, meaning a percentage of the RRIF must be withdrawn each year, and that withdrawal amount is taxable as income at the investor’s personal tax rate.
Administratively, the transfer from an RRSP to a RRIF is straightforward. It involves the submission of RRIF account opening documents to the investor’s custodian or investment dealer and a subsequent transfer request to move the RRSP assets over to the new RRIF. In almost all cases the RRSP assets — stocks, bonds, ETFs, mutual funds, GICs or whatever — can be moved ‘in-kind’ to the RRIF. Therefore, the RRSP-to-RRIF transfer in of itself does not necessarily require the investor to re-evaluate or change their overall portfolio profile, but the exercise certainly brings to light important tax-planning considerations.
Early RRSP Withdrawals — Strategically Created Income
Let’s take a moment to review the basics of RRIF withdrawals. Minimum required withdrawals are established by the CRA and are a function of two factors: age and the value of the RRIF at the end of the previous calendar year. For example, the first year an investor is required to make a withdrawal is the year in which they turn 72. (Remember, they transferred the RRSP assets to the RRIF during the year in which they turned 71, but no actual withdrawal occurred that year.)
The CRA mandates that the minimum required withdrawal at age 72 is 5.28% of the December 31 RRIF market value. (See the full withdrawal chart here.) So, if on December 31, 2018, the fair market value of the RRIF was $100,000, the turning-72-year-old RRIF account holder is required to draw $5,280 from the RRIF in 2019. At year-end, the custodian provides the RRIF holder with a tax slip for $5,280, which the investor then claims as income.
The key takeaway here is that the withdrawal is fully taxed as income. Early RRSP and RRIF withdrawals therefore create an opportunity for savvy investors to control their income levels in the years leading up to the mandatory conversion at age 71.
If a RRIF’s future withdrawals will be particularly large in light of the client’s current income profile, they will drive the investor into a higher tax bracket. In the years leading up to the mandatory conversion, investors can voluntarily draw funds from their RRSP, thereby strategically creating additional taxable income. For example, a 65-year-old retiree with a $25,000 annual income and a $1,000,000 RRSP may choose to draw, say, $20,000 from their RRSP. Because the investor started out in a low tax bracket, the additional $20,000 will not increase their income to such an extent that it pushes them into a higher tax bracket. The $20,000 withdrawal is therefore taxed at a lower rate today vs. what will apply when, at age 72 and thereafter, mandatory RRIF withdrawals push the investor into a higher tax bracket.
The Pension Income Tax Credit
The Pension Income Tax Credit is available if you are 65 or older. Simply, the CRA allows a $2,000 ‘pension income’ tax credit in the years leading up to the mandatory RRIF conversion at age 71.
Importantly, the pension income must come from a RRIF, an annuity or a company pension — not an RRSP. One way to take advantage of this tax credit would be to open a RRIF at age 65, transfer $12,000 to the RRIF from an RRSP and take $2,000 out per year from age 65 to 71. Effectively, this allows the taxpayer to draw $2,000 per year out of their RRSP/RRIF tax-free for six years. Per couple, this amounts to $24,000 worth of tax-free income over the six-year period.
Withdrawals Based on Spouse’s Age
Though the RRSP-to-RRIF conversion at age 71 is unavoidable, the CRA does allow an account holder to use their spouse’s age as the basis for their RRIF withdrawals. Those who wish to minimize their taxable income might choose this option if their spouse is younger, as the mandatory RRIF withdrawals will then be lower than what they otherwise would have been if based on their own age.
Though tempting, we should not be too critical of CRA rules regarding mandatory RRIF withdrawals. However unpleasant the tax hit may be in retirement in regards to such withdrawals, in almost all cases investors are wealthier than they would otherwise be had they not received the benefit of tax deductions for their RRSP contributions and enjoyed decades-upon-decades of tax-free investment growth within their registered accounts.
If you have questions about converting or consolidating RRSPs, please feel free to call us as we would be pleased to help you determine the best route forward.