Many of us on the financial independence retire early journey put a lot of attention and time on the accumulation phase- how much money should I invest each month, which index ETFs and individual stock to invest in, should I invest in TFSA or RRSP first, etc. The accumulation phase is extremely important because it sets you up for future years. However, as we proceed on the FIRE journey, we need to put more attention to the decumulation phase.
To be more specific, how can we make early withdrawals from the different investment accounts while being as tax efficient as possible?
Being as tax efficient as possible doesn’t mean tax evasion and deliberately avoiding taxes. Personally, I think it’s a privilege to live in Canada. We enjoy many social benefits, like universal healthcare and free K-12 education. Therefore, it’s important for us Canadian and permanent residents to pay the appropriate levels of taxes so we can continue to enjoy these great social benefits.
The key here is, as I already stated, is to be as tax efficient as possible and not pay more than one has to. The most important factor one has to consider when it comes to withdrawal tax efficiency, is how to make RRSP withdrawals while minimizing the amount of taxes you have to pay.
Recently I published an article on our early withdrawal strategies and how we plan to keep more money. Afterward, a few readers reached out for follow-up discussions. I particularly enjoyed an extended discussion with one reader (let’s call him Reader M). With Reader M’s agreement, I have decided to share the discussion with slight modifications.
Early withdrawal strategies – a reader’s discussion
Interesting to read your blog on decumulation strategies and good for you to get started thinking early on that.
Withdrawal strategies is a topic I have been thinking about a lot for the past couple of years. I’m a DIY investor and have been for a couple of decades or so.
Like you, my wife and I each have RRSPs, TFSAs, and taxable investment accounts. We also have no pension income to look forward to, apart from the relatively small stream from CPP/OAS eventually.
Unlike you, we are older (I turn 60 at the end of the year), and still working, and won’t be attempting as lengthy a retirement as you likely will be.
Tawcan: A quick clarification, although we have the goal of reaching financial independence by 2025 or earlier, we may not stop working completely when we are financially independent. It’s quite likely that we will continue to earn working income in some form or another. We simply would have the power to choose what we want to do.
How to minimize RRSP withdrawal taxes
Although it may not technically be decumulation, my recent thinking has been focused on the fact that the bulk of our liquid investments are in the RRSPs. This creates some issues. One aspect is that I definitely want to have the tax deferment work out in our favour.
In other words, I want to be doing my RRSP withdrawals at a lower tax rate (similar to your financial independence assumptions) than the one we deferred when making the contributions. But with sizable RRSPs, and the intention to remain invested through retirement, the question becomes how to manage that.
Start with the idea that, from an income tax perspective, the worst-case scenario is dying during one’s final year before retiring. This would result in the entire balance in one’s RRSP landing as income, in addition to one’s other income during the final pre-retirement year, during the year of death. The income tax on the total RRSP would be over 50%.
In terms of managing the tax deferment in one’s favour (or maybe more significantly, in one’s family’s favour), this is a horrible result. All of the income would have been deferred for all of those years, only to end up paying a giant chunk of money to the government at the absolute top marginal rate.
Of course, there is a provision in the law for rolling one’s RRSP assets over to one’s surviving spouse via an election, and thus further postponing the payment of income tax to square up the deferral. For practical purposes though, this actually amplifies the challenge of withdrawing the RRSP funds on a tax-efficient basis because the surviving spouse can end up with an RRSP that is too big for a single person to effectively draw down.
Tawcan: You made a very good point. While you can pass your RRSP to the surviving spouse, the surviving spouse will end up with a large RRSP and get taxed even more. So I still think it is a good idea to withdraw some portion of the RRSP before age 71.
If you decide to convert RRSP to RRIF, make sure it’s not a sizable amount of money and you can then treat RRIF as a personal pension. Reader B mentioned something similar when it comes to investment assets in the taxable accounts.
- Living off dividends – How I’m receiving $360 dividends a year & paying almost no taxes
- Living off dividends – My $360k per year dividend income
For example, a $2M RRSP generating a 5% average investment return would have to be drawn down by over $100,000 annually or else it would not be reduced at all. In my view, the plan should be to reduce the RRSP/RRIF ultimately to zero and collapse it. That would mean that it would need to be drawn down by a significant amount higher than the $100,000, even if it were stretched over say a 20-year period.
But if you are pulling significantly more than $100,000 from an RRSP annually, you are paying a lot of income tax, plus likely losing your entire OAS income amount to the clawback. So if you have a seven-figure RRSP balance, it can be really tough to make the tax deferral work out in your favour and avoid giving a giant chunk to the government.
Now my presumption of course is that I am not going to die just before retiring and that I will have a decent length of retirement time to draw down my RRSP – you sort of have to presume that because you need to plan to manage your expenses in case you live to a ripe old age.
If I want to help create some “income room” that I can use for the RRSP drawdown, I can defer both CPP and OAS until I am 70. I’ll have to deal with the fact that I’ll get more money from them then, but that isn’t the worst of all worlds. That way, if I retire “soon” I may have 8 or 9 years to draw down the RRSP before the government money kicks in.
Now I want to digress here to point out that the least of my worries is the mandatory RRIF withdrawal rates; I think it only makes sense to be drawing down the RRSP at a faster rate than the minimum required under the RRIF rules. So I view them as essentially irrelevant.
Tawcan: When I mentioned the mandatory RRIF withdrawal rate in the early withdrawal strategies article, I meant that if we don’t do anything to our RRSP (i.e. make any withdrawals), we would end up with a significant large RRIF, forcing us to have to make large withdrawals later on in life and get hit with a large tax bill. It sounds like both of us have the same thoughts in terms of withdrawing some portion of money from our RRSP before or shortly after retirement, before CCP and OAS kick in.
Another key thing to consider is health. If you can delay CCP and OAS until age 70, that’d be ideal.
I’m thinking it will make sense to start drawing about $70k from my RRSP annually (maybe index that number in a ballpark way). If I want to keep my taxable income under $85k in today’s terms, which makes some sense from a tax bracket perspective because it provides a relatively reasonable average tax rate.
Once I am 70, I might have $12k or $14k in taxable government benefits to make room for, so I’d need to slice the RRSP drawdown back to about 60k annually to keep me below the clawback threshold.
In the mix, I’m allowing myself about $15k per year of flexibility, to deal with the fact that I will also have taxable investments and it is possible I’ll have to manage some dividend income and take some capital gains along the way as part of prudent investment management. That would of course require some available income room under the target $85k maximum, for tax purposes (watch out for what that dividend gross-up/tax credit scheme does to your taxable income – for clawback threshold purposes!).
Now the reason that I say my planning may not be entirely a decumulation strategy is that I’m not really intending to immediately spend all of the money that is withdrawn from the RRSP. Instead, the idea is to get it out at a reasonable tax rate in order to get a significant chunk of it reinvested, in the TFSA as a first priority but also significantly in the taxable account, which I expect to keep growing until the RRSP is eventually exhausted. However, if I get a decent ROI in the RRSP, it won’t likely be exhausted until after I’m 80.
Some people claim not to care about what they may be leaving behind for kids and grandkids. That’s not me. I do care about that.
The “withdraw efficiently to invest outside” plan is supported by the fact that my wife is younger than I am, earns more than I do and will likely continue to do so for a handful of years while I get started drawing down my RRSP. Eventually, if I can make enough headway on my drawdown, we may be able to take advantage of pension income splitting to help my wife get some drawdown on her RRSP. Hers will be bigger than mine (and more challenging to reduce); it is already bigger and presumably will continue to grow for several more years.
If one is trying to use as much income room as possible for drawing down the RRSP, one doesn’t really want other income getting in the way and messing up the tax planning. So while I am devoting my income to drawing down my RRSP, my intention is to avoid generating a significant amount of dividend income in my taxable account. What I’d prefer are long-term-style investments that can accumulate capital gains without requiring too much turnover.
I use HXS and HXQ as non-dividend generating index ETFs at present and will likely continue as long as they provide that possibility. Payers of significant dividends can be allocated to the RRSP/RRIF and TFSA – how’s that for a counter-intuitive twist.
Tawcan: An interesting point. Investing in non-dividend ETFs/stocks in taxable accounts does make some sense to me, especially in retirement years as a way to be as tax efficient as possible. But I suppose it really depends on what your “other” income would be and your marginal tax rate when you are utilizing your investment portfolio. It is not a one size fits all solution and will depend on your situation. This is why personal finance is personal.
Utilizing TFSA in retirement
Tawcan: Withdrawing money from RRSP then contributing the money to TFSA and/or taxable accounts is what we plan to do. It’s really too bad TFSA has such a low yearly limit. It would be great if the government can re-introduce the $10k a year limit. But I don’t see that ever happening.
I am not sure if there are any benefits to this idea, it might be worth exploring further. A potential idea would be to take out a large chunk of money (say $50K) from your TFSA just before the end of the calendar year and put the money in your taxable account. You’d then make a withdrawal of the same amount of money from your RRSP or RRIF. At the new calendar year and when your TFSA contribution limit resets (plus the additional contribution room), deposit the money from RRSP/RRIF in your TFSA. Repeat this process a few times.
This way your RRSP withdrawals can compound tax-free in your TFSA for a year before getting rolled into the taxable account. The tricky thing here is to determine the amount so you don’t end up paying too much taxes on the RRSP withdrawal. Furthermore, there’s always an opportunity cost disadvantage to withdrawal from the TFSA.
An interesting idea! I don’t think it generally works in one’s favour because, apart from the contribution size restriction, the TFSA is really the ideal investment environment. So there is always an opportunity cost disadvantage to withdrawing from it that has to be outweighed by something in order to justify the strategy.
Another potential justifying circumstance might be if one wanted to invest that TFSA cash (no other source being available) in something with a higher risk profile, such that one wouldn’t want to risk destroying the TFSA room, if the investment were to go the wrong way. Then maybe one wouldn’t want to try it in the TFSA.
So in the example, you suggested, I don’t think starting with the TFSA withdrawal actually gains you any ground. Doing it near the end of the year would minimize the time of holding empty TFSA space before re-contribution is allowable (must be subsequent calendar year). But ultimately the withdrawal and deposit would likely cancel out each other’s effects and you’d be down the additional transaction fees. Ideally, you just want as much invested in your TFSA as you can legally hold and for as long as possible.
Should I invest in RRSP now or wait until later?
Tawcan: One final question for you, if you knew about the limitation of RRSP 10 to 20 years ago, would you have done the same with your RRSP? Or would you have limited how much you contribute to RRSP each year?
This is a tricky question because the fact that the future is unknowable plays into this scenario. One thing I would have spent more time thinking about is when it makes sense to begin contributing to an RRSP. In retrospect, I probably began RRSP contributions a little bit too early and my wife probably did as well.
Think about it this way: the very first money I put into my RRSP will probably come out at a higher income tax rate than was deferred at the time of contribution. There is something to be said for saving RRSP contribution room for a while, while one’s highest marginal tax rate is working its way up the scale. But on balance, I likely would not have done much differently because I really didn’t have any idea what my future income level would be, and especially what my wife’s future income level would be, by the time we were over 50.
Tawcan: Not to mention the money in the RRSP will be compounding tax-deferred.
I also had no way of knowing that we would have such a significant ROI result for the years 2019, 2020, and so far in 2021. A stretch of returns like that can really move the needle for the account size. For example, you have shown that your 2020 investments have done really well.
To get these kinds of returns after having built up a reasonably substantial ‘account value’ is great but in no way could have been reliably predicted during the first 15 or 16 years of contributions.
I think prudence requires planning for the potential of less successful scenarios and as part of that, maxing out RRSP contributions along the way as my wife and I did was the right thing to do. It is also a good habit to develop I think, as opposed to some of the alternatives.
So while ending up with very substantial RRSPs raises some issues and requires some additional planning, it was the objective all the way along and I think it is the good sort of ‘problem’ to have at this stage. Giving a little more to the government is less problematic than ending up without enough to live comfortably on; and if I had ended up with significantly less in my RRSP as a result of lower ROI, then the RRSP account would still have been the right saving/investment platform for me.
Tawcan: an excellent point indeed! I started contributing to my RRSP and max it out when I started working 15 years ago. Back then I didn’t consider the withdrawal tax consequences either. However, if we are worrying about RRSP withdrawal taxes, that means the investments have done well and that the RRSP has grown to a sizable amount. Both of which are very good problems to deal with. It’s better to have more money for retirement and have to pay taxes than not having enough money for your retirement.
Thank you Reader M for our thoughtful email exchanges and for allowing me to publish our exchanges into a blog article. Connecting with other like-minded people is something I really enjoy.
As you can see, the decumulation phase can be complicated and we all should pay more attention to this important phase. Years ago, the RRSP was the only tax-advantaged savings vehicle that Canadians could utilize. The introduction of TFSAs certainly complicates the tax simulation and calculation in retirement years. But I believe having more options available is always a good thing.
Because we are all different, there is no one size fits all solution when it comes to early withdrawal strategies. It is therefore vital to develop multiple plans and have different options. More importantly, I think it’s important to be open to different ideas and allow yourself to change your plans accordingly.
And as mentioned before, worrying about RRSP withdrawal taxes and trying to avoid OAS clawbacks is a good problem to have. It only means that you have done well with your investments. It is not the end of the world if you end up paying a little more taxes. There are more important things in life than minimizing taxes.
Mrs. T and I continue to feel very fortunate that we are doing well financially and we are on track to reach financial independence before the end of this decade. Given everything that’s happening in the world, there are many people that desperately need a helping hand. Therefore, I think it is far more important to give. If you’re reading this, I’d strongly encourage you to donate your time and money to charities and try to make this world a better place.
Sadly, there are far too many divisions in the world today. Rather than creating more divisions, let’s remove these divisions and barriers, come together, and make this world a better place.