Many people spend their working years accumulating a sizable RRSP (Registered Retirement Savings Plan) account and as they approach retirement start to wonder about the specifics of when and how to draw on this nest egg for retirement spending needs.
RRSP to RRIF: How does it work?
Picture your RRSP as a savings bucket. Each year as you put savings into the bucket you asked the government to give you an I-owe-you on the taxation of this money. In essence you said, ‘Please don’t tax me on this portion of income (your RRSP contribution) this year because I am in a high tax bracket and I am saving it inside my RRSP (your RRSP tax deduction). In exchange, I will pay tax on it later in retirement when I draw it out as income.’ This is referred to as a tax deferral. An RRSP works well when you defer tax from a year when you are in a high tax bracket, to be paid later when you are in a low tax bracket.
It is important to understand this basic principal of tax deferral in order to appreciate how these savings are taxed in retirement. You can convert your RRSP to a RRIF (Registered Retirement Income Fund) or an annuity. Let’s take a closer look at the RRSP to RRIF scenario.
I like to use a bucket analogy. As the name suggests, a Registered Retirement Savings Plan (RRSP) is the bucket where you save the money. At some point you will convert this RRSP over to another bucket called a Registered Retirement Income Fund (RRIF) which also, as the name suggests, is where you draw income to spend. The RRSP bucket is where you put the savings each year in the top, and the RRIF bucket is where you cut a small hole in the bottom to start to withdraw savings out each year.
When to convert from RRSP to RRIF
There are a number of factors to consider when deciding the best time for you to convert from an RRSP to a RRIF including; your other savings, pensions and sources of income, your planned retirement date, and when you plan to draw Canada Pension Plan (CPP) and Old Age Security (OAS), among other things.
As a rule, your RRSP must be converted to a RRIF no later than December 31st of the calendar year you turn age 71. There is an exception to this rule when you have a younger spouse as you can choose to use their age 71 if it makes sense for you to do so.
Work with your financial advisor to decide on the best timing for you to convert from RRSP to RRIF to illustrate scenarios for flow of income in retirement taking these factors into consideration.
An RRSP to RRIF conversion is done in a tax sheltered way so as not to trigger a tax liability upon conversion. The tax liability will begin with the RRIF income, not with the conversion itself.
How much income will I get from my RRIF?
Once your RRSP has been converted to a RRIF you will figure out how much income to draw from it each year.
There are some tax implications when choosing how much money to draw from your RRIF each year. Remember, this is money you still need to pay income tax on. So as a result, you want to be strategic in how you withdraw these funds.
While there are no maximums, RRIF’s do have minimum withdrawal rules which need to be considered. Essentially, the government sets out a schedule of minimum withdrawal levels that must be taken from each person’s RRIF expressed as a percentage of the portfolio and based on their age.
For example, if you are age 75 the current RRIF minimum is 5.82%. If your RRIF balance is $100,000, the minimum amount you must withdraw from your RRIF for that calendar year is $5,820. The minimum percentages increase for each age. (i.e. currently age 75 is 5.82%, age 76 is 5.98%, age 77 is 6.17% etc) These formulas are based on age and portfolio balance on January 1st of any given year.
RRIF income and after-tax financial planning
Although the government sets minimum annual RRIF withdrawal rates, and the maximum age 71 for conversion to RRIF, these are merely minimum and maximum parameters. You and your tax and financial advisor should determine how to work within these parameters in a way that makes the most sense for you.
There are many strategies to be considered for converting to a RRIF at a younger age and for drawing income above the minimum levels, especially if de-registration and estate planning strategies are being employed. These strategies are done with after-tax planning in mind to maximize assets and income after taxes on an ongoing basis. Taxes. Pay less, keep more; with after tax planning.
Many people erroneously believe these strategies are only for the wealthy, which is not true. Advice. What’s it worth? Everyone can and should benefit from after tax planning and the ability to make a long term plan to maximize their savings and assets and reduce taxes wherever possible.
Stephanie Farrow, B.A., CFP., Stephanie has over 20 years experience in the financial services industry, a diploma in Financial Planning from the Canadian Institute of Financial Planning and a Certified Financial Planner designation. Stephanie has been writing financial planning columns for local business magazine Elgin This Month since 2010. Stephanie and her husband Ken Farrow own Farrow Financial Services Inc. About our Farrow Financial Team.