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 free health care, infrastructure repairs, or public transit to name a few things.
The reality is that we all know taxes are a necessary evil if we want to live the lifestyle we are accustomed to. 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.
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 refund you get from making an RRSP contribution, there are a number of things to consider if you decide to put all of your eggs in this one basket.
- Yes, you will receive a refund from your contribution (assuming you would be net zero owing before the contribution and assuming you have enough income to be offset by the contribution) but what will you do with that refund? Will you spend it or invest it back to the RSP or TFSA or something else? If you save it, an argument could be made that this may be a good strategy, however, very few people save their refunds.
- 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 CPP and OAS when it starts rolling in. Your tax rate may be higher than before retirement.
- Payments from a RRIF (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. 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.
As you likely know, with a Tax Free Savings Account (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 RSP, but the contributions are not tax deductible like an RSP’s. The bonus though is that, as with RSP’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.
This is where investments get interesting. You can open a non-registered investment account (aka Open Account, IA, etc) and save into a number of holdings including stocks, funds, segregated funds, etc. The issue with holding these is that they would be subject to taxation on the distributions and redemption in any given year, whereas, registered accounts grow tax deferred.
Investments 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 RSP 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.
Until next time!
Have any questions for Mike? You can write a comment below. Want a second opinion on your investment strategies? Contact Mike.
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