As many investors will likely have multiple sources of income in retirement, it’s important to consider how to draw down retirement savings in a tax-efficient manner.
Common sources of retirement income include pensions, government benefits, registered plans, and non-registered investments. The sequence of withdrawals – meaning which account is withdrawn from first – may have tax implications for the retiree. It’s essential for investors to understand that some sources of income are taxed differently than others, as this will impact retirement savings.
Layering Income Sources to Draw Funds for Retirement
Layering different guaranteed and non-guaranteed income sources may be a tax-efficient strategy for drawing down retirement savings.
Individuals may receive retirement benefits from the Canadian government based on their income and contributions during their working years. The three primary government benefits include the Canada Pension Plan (CPP)/ Quebec Pension Plan (QPP), Old Age Security (OAS), and a Guaranteed Income Supplement (GIS).
CPP monthly distributions, which are taxable, can begin at age 65. The payment amounts depend on the premiums contributed to the plan and the age at which the individual begins receiving payments.
On the other hand, OAS monthly payments are taxable and payable to Canadians aged 65 or older but do not require contributions to the plan. However, the number of years the individual has resided in Canada is considered. Additionally, the benefit amount may be clawed back if the annual income exceeds the OAS threshold.
Individuals who receive OAS may also qualify for GIS, which is not taxable if their annual income is lower than the yearly maximum exemption amount. However, GIS will be eliminated if the taxpayer’s annual earnings income exceeds an amount specified by the government of Canada.
Individuals have some flexibility when they choose to receive CPP and OAS.
CPP benefits can be received as early as age 60, but the payment will be reduced by 0.6% each month before age 65. Conversely, there is a 0.7% increase for each month the CPP payment is deferred beyond age 65, up to a maximum 42% increase at age 70.
In addition to receiving larger monthly payments, a key benefit of deferring payments can be managing tax brackets. As OAS would be clawed back when annual income exceeds the threshold, deferring income from CPP or OAS benefits may reduce the clawback.
Private Pensions
Employer-sponsored private pension plans are often referred to as Registered Pension Plans (RPPs). RPPs can be defined benefit (DB) or defined contribution (DC) plans, and participants receive periodic monthly pension payments upon retirement. Payments from all private pensions are taxable.
How Registered Plans Factor Into Retirement Savings
Investors can also save for retirement with registered plans, such as a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
Under age 71, an individual is not obligated to withdraw from an RRSP and can control the timing and amount of withdrawal.
On or before December 31 of the year the individual turns 71, the individual must withdraw the entire RRSP amount, transfer funds to a Registered Retirement Income Fund (RRIF), or purchase an annuity. Transferring funds to a RRIF or purchasing an annuity will defer the income needed to be reported that year, and the payments can be set to smaller, periodic payments that are taxed over time.
It is important to note that an RRSP can also be converted to an RRIF before age 71. If an individual is older than 65 and not receiving other pension income, they may consider converting a portion or all of the RRSP to an RRIF. By doing this, they take advantage of the pension income amount to withdraw up to $2,000 per year tax-free. However, once the amount is converted to an RRIF, the minimum payments will begin in the year after the setup, and no contributions can be made to the RRIF.
The best time to draw on an RRSP depends on the individual’s situation. However, generally, individuals may consider contributing to RRSPs in higher income years and withdrawing when their tax bracket is lower.
All RRSP or RRIF (or registered annuity) withdrawals are fully taxable.
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