Canadians pay our fair share of taxes to ensure we have access to social programs and services. But there’s no reason to pay too much tax in retirement. These are seven ways I help my clients to reduce their obligation and pay no more tax than necessary.
Use Your Tax Brackets
Not all of your income is taxed at the same rate. In Canada, we feel that people with lower income should pay less tax, and people with higher income should pay more tax. We accomplish that by setting different tax rates for different levels of income. (Federal and provincial governments set their own tax brackets.)
The same tax rate applies to all of the income within a tax bracket. It follows that it’s best to keep your income below the cutoff, and also that it’s optimal to take income up to the cutoff. If you can choose whether to take income from taxable or non-taxable sources, as well as splitting income between spouses, you can optimize your taxation. It’s important to balance taking income up to a tax bracket with the impact on government benefits and tax credits.
Income Splitting to Reduce Tax in Retirement
For people who have a spouse, there are a number of ways you may split income. If both spouses are in the same tax bracket, it won’t have much effect. But if one spouse is in a higher tax bracket, they will benefit from being able to move that income to the spouse in the lower tax bracket.
When you apply to begin receiving CPP income, it’s possible to assign up to 50% to your spouse. If both spouses do this, they will both receive equal income. But if one spouse has a much lower income, it could help to maximize their taxable CPP income by splitting only the CPP of the higher-income spouse.
Pension income is different because it can be split on the tax return. Even if one spouse earns more pension income, it can be claimed on the lower-income spouse’s tax return. Pension income qualifies from a defined benefit pension plan or annuity before age 65 or from a RRIF after age 65.
There are two ways to move money into your spouse’s name in preparation for retirement. Spousal RRSPs can work very well to equalize assets and create more flexibility when drawing income. This can also work if the contributing spouse is over 71, but the spousal is under 71 so contributions can still be made in their name. There is a three-year rule about spousal RRSP withdrawals to keep in mind. It is also possible to contribute to the TFSA of your spouse without any withdrawal restrictions.
For anyone who has used all the ideas above and still needs additional income splitting, more advanced strategies include: prescribed rate loans, a spousal trust or a family trust. I can discuss these ideas and we would need to involve an accountant and/or lawyer to set it up.
Sheltering Income from Tax in Retirement
RRSPs typically no longer provide deductions in retirement, since their intent is to produce income in retirement. You may offset the tax from receiving a single lump sum or realizing a one-time capital gain by making an RRSP contribution, if you have the room. For people over age 71, a spousal RRSP contribution can be made if the spouse is younger than 71. The government will allow a final over-contribution of $2,000, useful for your last contribution.
TFSAs in retirement provide no deduction, but they shelter interest, dividends and growth from tax. It can help to redirect excess cash flow (OAS, GIS, CPP, RRIF min) into a TFSA and shelter any future growth from tax. It can also provide a source of additional cash flow for highly taxed retirees. A TFSA produces non-taxable withdrawals which can balance taxable income.
Some people retire with investments in non-registered accounts. A T series mutual fund or a prescribed annuity can produce a more tax-efficient income stream from these accounts.
Income from Registered Plans
An RRSP or LIRA must be converted to a RRIF or LIF (or annuity) by the end of the year when you turn 71. However, there is no date when it is too early to draw income from an RRSP. Many people need the additional income when they retire. At the time of conversion from RRSP to RRIF, you have the option of basing the minimum income on the younger spouse’s age. Doing so gives you greater flexibility, especially if you have other sources of income (e.g. TFSA, non-registered, pension, etc.).
In many provinces, including Alberta, when converting a LIRA to a LIF, you have the option to unlock up to 50% of the value of the LIRA. This would mean transferring the value to your RRSP (tax-deferred) or chequing account (a taxable withdrawal). If that leaves a small amount in the LIRA, that can also be unlocked. Unlocking a LIRA increases flexibility, but leaves you responsible to ensure you have income for life.
If you don’t need the income at age 65, it may still make sense to make RRSP/RRIF withdrawals of at least $2,000 per year to take advantage of the pension income tax credit.
You should have a named beneficiary on your RRSP or RRIF. If you name your spouse as your beneficiary, your registered plan can roll to your spouse tax-deferred. This means they receive the full value of your investments and can continue to draw taxable income. At the end of the second life, the full amount is taxed as income in the year of death. If your beneficiary is someone other that your spouse (or a dependant child or grandchild in certain circumstances), the full amount will be taxable as income in the year of death.
RRSP Exit Plan
Many financial advisors rely on financial planning software that recommends deferring registered (e.g. RRIF) income as late as possible. For a single person with no beneficiaries, this strategy is fine. However, in the case of a couple who both have RRSPs and wish to leave the remainder to their beneficiaries, it could result in a huge tax bill on the second death. You could lose 50% or more of your registered plan to taxes.
As an alternative, you will only owe 25% taxes on income up to $48,000 (in Alberta). Quite a tax savings, by comparison. Whether or not you need the income, withdrawing from your RRIF can take advantage of the lower tax brackets. This allows you to fund your living expenses, use some income splitting and tax credits, and potentially fund your TFSA and non-registered investments.
During your lifetime, you will have greater flexibility to draw from taxable or non-taxable income. At the end of your life, with much of your money already taxed, the tax loss will be lower and more money will go to your beneficiaries.
Tax Credits in Retirement
Retirees don’t have access to many deductions, but can access a number of tax credits. Tax credits offset taxes otherwise owing, so they have a similar effect to tax deductions, except they don’t keep income from surpassing cutoffs such as qualification for GIS and clawback for OAS as well as tax brackets for calculating income tax.
The basic personal amount is just over $12,000. Add to that the age amount, a credit that applies to $7,637 of income for taxpayers age 65 or older. That means seniors don’t pay tax on their first $19,600 approximately of income. The pension income amount adds another $2,000 for qualifying income.
Seniors may qualify for a disability tax credit. The CRA must approve this credit and the application needs to be completed with your doctor. In addition, medical expenses and attendant care expenses, if you pay them, may be deductible.
When to Start CPP & OAS
When to start CPP & OAS entails a number of considerations to make sure you get it right for your situation. That’s why I covered it in a separate article.