by Mike Onotsky
Yes, everyone it’s the dreaded T word - Taxes. We all hate taxes but we know without them we would not have health care, infrastructure repairs, or education for our children.
The reality is that we all know taxes are a necessary evil if we want to live in the society to which we are accustomed. Today what I want to discuss is paying our fair share, but not a penny more. As I am not an accountant, I will reserve conversation about tax savings, other than in the investment world, to someone else.
Registered Retirement Savings Plan (RRSP)
When it comes to saving for retirement, the first thing that comes to mind (aside from any pensions someone might have) is to make an RRSP contribution. While everyone loves the tax refund you get from making an RRSP contribution, there are a number of things to consider if you decided to put all of your eggs in this one basket.
- Yes, you could receive a tax refund from your contribution. What will you do with that refund? Will you spend it or save it?
- What will your tax bracket be in retirement? If you do a great job of saving and/or if you have a great pension, your retirement income might be higher, especially with your Canada Pension Plan (CPP) and Old Age Security (OAS) when it starts rolling in. Your tax rate may be higher than before retirement.
- Payments from a Registered Retirement Income Fund (RRIF), which is what you convert your RRSP to once you want a steady income stream and before the end of the year you turn 71, are all considered to be straight income. This means they are fully taxable even if the underlying investments provided more tax efficient distributions like dividends and capital gains.
- As these distributions are considered income, if your total income (including RRIF, CPP, OAS, pension, and other income) are too high, your OAS may be clawed back either partially or in whole.
- Once you turn 71 and must convert your RRSP to a RRIF, you will have a fixed income stream that has a minimum amount that must be paid out each year and that percentage increases each year.
Bottom line is that with all of your eggs in an RRSP/RRIF basket, you could wind up paying more in taxes in your lifetime IN TOTAL than you might utilizing other strategies.
Tax Free Savings Account (TFSA)
As you likely know, with a TFSA you can put away an amount each year (up to that year’s maximum) into an investment account that can hold the same investments as your RRSP, but the contributions are not tax deductible like an RRSP’s.
The bonus though is that, as with RRSP’s your investments grow tax deferred and, should you redeem any holdings in your lifetime, there is no taxable event created by the redemption. No, you don’t get a refund but also no, you won’t have to pay taxes when you want to use your money.
I should add that as long as you provide a successor annuitant or beneficiary to the account, there will be no taxes paid upon your passing either.
As such, a TFSA could be an excellent savings vehicle for retirement income if you are concerned that you may generate too much taxable income in retirement.
Still With Me? Non-Registered Investments
This is where investments get interesting. You can also open a non-registered investment account and save into a number of holdings including stocks, segregated funds, and others. The issue with holding these is that they would be subject to taxation on the distributions and redemptions in any given year, whereas, registered accounts grow tax deferred.
Investments like this generate three basic forms of income; interest income, dividend income, and capital gains income. Interest income is taxed at 100% just like employment income and just like RRIF income as described above. Canadian dividend income is taxed more favorably through the dividend tax credit and capital gains income is taxed significantly less than interest income.
The advantage from a retirement income planning perspective, is that while taxes are paid annually NOW on the non-registered holdings in your portfolio, they will be taxed a lot less than your RRIF income in retirement. In addition, there is no minimum to take out at any age so YOU control when you withdraw and how much which is great for the retirement years where you may have a higher than normal income need one year but want less most years. Much more flexibility at a lower retirement tax cost.
In a perfect world, you would hold all three accounts. If you have no pension, saving to an RRSP is good, however, do not neglect saving to your TFSA as well. If you wind up maxing out your TFSA, then start saving to a non-registered investment account. Ideally, retiring with a good mix of holdings in all accounts gives you the most flexibility with the least tax hit now and in retirement.
Another important recommendation if you have both registered and non-registered accounts is to split up your holdings based on type (assuming the goal is all for retirement) and have all of the equities (stocks) in the non-registered account and all of the more conservative (fixed income) holdings in your RRSP or TFSA account.
Since the RRIF income that will come from your RRSP one day is fully taxable anyway, it does not matter what type of funds or holdings are in there. On the non-registered side, however, the more you hold in equities, the less taxes you will pay since it is the equities that generate capital gains and dividend income which, if you will recall, are taxed more favorably. You can maintain the same overall risk level as you did when everything was in just your RRSP account, however, with funds split between the two account types, your tax effect would be better than if you simply mirrored the same holdings in both account types.
Once again, all of these things are items your financial planner should be discussing and planning with you. In the end, focusing on these things as part of your overall strategy will keep more money in your pocket over your lifetime.
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