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Tax bracket management key to maximizing retirement income

To keep taxes down, map out a strategy in early retirement with a financial advisor or tax consultant


Date: September 26,2014

Most Canadians have heard the message about the need to save for their retirement. But one thing they may not realize is how taxes may reduce those savings just when they are needed most.

“It’s a big issue,” says Peter Bowen, vice-president of tax research at Fidelity Investments Canada. “There is a tidal wave of baby boomers hitting retirement. If they’re not careful they’ll end up paying more taxes than they need to.”

The good news is there are some relatively simple ways to minimize taxes and maximize cash flow in retirement.

The key issue, according to Mr. Bowen, is tax-bracket management. He notes that at different times in retirement individuals will be paying different tax rates. Just after retirement the tax rate will usually be low, but it generally increases over time. That increase is usually related to individuals beginning to receive specific income payouts. The main payouts are from the Canada Pension Plan (CPP), the Old Age Security (OAS) pension, and income from individuals’ own registered retirement savings plan (RRSP).

The way Mr. Bowen sees it, there are two main decisions for individuals to make as far as managing their retirement tax situation. The first is when to begin receiving CPP and OAS benefits. The standard age to begin receiving CPP is 65. However, one can take a permanently reduced CPP retirement pension as early as age 60, or one can choose to delay taking it as late as age 70, permanently increasing the payments. Similarly, OAS payments usually begin at age 65 but can be delayed by up to 60 months after the first date of eligibility in exchange for a higher monthly amount.

There are two reasons an individual might choose to delay these payments. The first is that the monthly amount paid increases. If a person chooses to delay CPP payments they receive an increase for each month they wait between the age of 65 and 70. Right now that increase works out to 0.70 per cent per month. The situation is essentially the same for OAS.

The other reason to defer benefits is tax management. This is particularly important with Old Age Security, as it is subject to the dreaded “OAS clawback.” The threshold changes from year to year, but currently individuals with incomes more than $71,000 a year will be hit by the OAS “pension recovery tax.” Fifteen per cent of income above the threshold will have to be repaid to the federal government.

As a result of these considerations it may make sense for some individuals to delay receiving some combination of their CPP or OAS benefits.

Once decisions have been made about when to take those benefits, the next key step, according to Mr. Bowen, is to convert some assets in registered accounts into non-registered holdings. This will trigger some taxable income while you are still in a relatively low tax bracket. Also, in early retirement it may make sense to move Canadian stocks that yield dividends from an RRSP into a non-registered account because any profits from Canadian dividends are given preferential tax treatment. Once that shift is made, profits and the resulting tax hits will be realized in a lower-tax period. One caution is that it is the grossed-up amount of Canadian dividends that counts for the OAS clawback.

Another shift mentioned by Mr. Bowen that may be effective for many people is transferring into “corporate-class” funds. Many mutual fund companies offer two kinds of funds: traditional and corporate class. Both are managed much the same way, and hold the same kinds of investments, but are structured differently, with the corporate-class structure offering greater tax efficiency. With corporate-class funds, when distributions are paid, they are classified as capital gains and/or dividend income, both of which are taxed at a preferential rate compared with interest income.

The timing of any asset shifts may also be co-ordinated to occur before receiving OAS payments. That includes any possible capital gains that may be triggered by the sale of assets. As well, once the investments are moved there is a need to consider the tax implications of the investments.

Karen Slezak also sees tax-bracket management as the key to retirement tax planning. Ms. Slezak is a partner in the tax group at accounting firm Crowe Soberman in Toronto. Another issue she highlights is the use of tax-free savings accounts (TFSAs). Specifically, she recommends moving $5,500 of investments annually to a TFSA to shelter tax on the income. As of 2013, that’s the maximum yearly amount an individual can contribute to a TFSA. If someone has never contributed, they can do a lump-sum transfer of $31,000 to a TFSA to catch up prior years’ room. However this works best for investments in non-registered accounts, as moving investments from an RRSP would trigger a tax hit.

Other ideas to reduce tax in retirement Ms. Slezak recommends include:

– Emphasizing investments that generate capital gains and dividends, because income from these sources is taxed at a lower rate. Investments that simply pay out income, such as guaranteed investment certificates (GICs), are taxed at a higher rate, and often have the added disadvantage of paying a low rate of return.

– Split pension income with a spouse to keep both individuals in the best possible tax bracket.

– Apply to split CPP with a spouse.

– Make charitable donations by gifting securities.

– Offset the tax on RRSP withdrawals by making matching charitable donations.

Ms. Slezak says even people in their 20s and 30s can start thinking about retirement planning by setting aside funds in an RRSP and using the tax refund to pay down debt. It becomes more critical by age 40 and definitely by age 50 to focus on maximizing retirement income and looking at ways to reduce taxes to achieve that goal.

“There’s a big opportunity for people to be thoughtful and careful about how and when they receive their cash flow,” says Fidelity’s Mr. Bowen. “It’s all about minimizing their tax bill and maximizing cash flow to ensure a comfortable retirement.”

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