Are excess savings in RRSPs going to create a problem for you in the future?

In our practice, we quite typically see retirees in receipt of pension incomes, CPP, OAS, — often doubled up in a household — whose core sources of predictable, inflation-adjusted income are adequate in themselves to pay the bills and still provide for lifestyle choices. Maybe they were ‘savers’ during their working years — or at least, people who didn’t waste money with extravagant spending – but they don’t feel that they are denying themselves anything in retirement and just don’t need or want any more income.

Through mandatory participation in employer and government sponsored pension plans, they accumulated this core retirement income, but they also tended to save money in RRSPs and/or accumulate non-registered funds along the way for retirement or a rainy day. Fast forward to retirement, and they might have $300,000 or more in their RRSPs and are not motivated to draw on them. We see this all the time. They don’t need the income and they don’t want to pay the tax on withdrawals. But the requirement to turn their RRSPs into RRIFs by the end of the year they turn 71, and then having to start the minimum annual withdrawal in the year they are 72, looms large. If the funds are invested for growth and/or they inherit extra RRSP balances when a spouse pre-deceases them, that liability increases with every year they defer withdrawals. By the time they must withdraw, the required minimum withdrawal may be large enough to not only attract higher marginal tax rates, but also cause them to lose the Age Credit and possibly have some OAS clawed back. This is a form of ‘double’ taxation. To top it all off, the Canada Revenue Agency stands to become a primary beneficiary of the balance in RRSPs and RRIFs at the last passing.

So, people who find themselves in this position can throw in the towel, take the withdrawals, pay the tax and increase their excess cash balances sitting in the bank — or they can consider the following strategy:

Melt down your RSP and the tax liability through a donor-directed charitable giving fund and direct your tax dollars to causes you care about.

We are frequently proposing this strategy to clients with surplus funds who want to manage the tax liability for RRSPs over the long term. Many money management firms offer an option to set up a donor-directed fund within a larger charitable giving foundation. You make an irrevocable donation to the foundation, but your portion is uniquely identified in the manner you wish (e.g. The John and Mary Smith Giving Fund) and you or your representative name the beneficiary organizations through standing or annual instructions.

Say you withdraw a lump sum from your RRSP, you can donate the gross amount – within the 75% rule — and generate a tax credit which is at the highest marginal federal/provincial rate. Depending on your situation, you may find that the tax credits significantly reduce your overall tax bill from what it would otherwise be. Even though you might be claiming additional taxable income before making an offsetting donation, the generous tax credits afforded to charitable donations could help you reduce your overall tax bill and leave you with more spendable income from your basic sources!

The donor-directed charitable giving fund strategy also offers a great option for shareholders with surplus funds in a personal corporation or holdco to get the funds out tax-effectively. Granted, you are transferring capital which cannot be accessed again, but you retain some control over its ultimate use (other than going to government tax revenues.) These charitable foundations often have a $10,000 – $25,000 minimum for the first contribution to a donor-directed fund, with additional contributions in the $1,000 – $5,000 range. And you can leave a final bequest to your fund in your will. Your legacy will continue long after you are gone.

This strategy is also applicable to taxpayers who regularly make generous charitable contributions anyway. It may be easier to do so on an ongoing basis by setting up a donor directed fund to make annual donations to your core causes.

Here’s an example of how the strategy might work for an individual taxpayer who draws $25,000 from his RRSP to donate to his donor-directed fund:

In this example, the taxpayer will lose some of the Age Amount tax credit, but he benefits from a charitable donation tax credit which is higher than his highest marginal tax rate on Net Income. His donation tax credit not only offsets the RRSP withdrawal, but actually contributes additional tax credits to his tax payable on the other income, so he ends up with more spendable income than he had before. And in a rising market, it might be that the contribution amount withdrawn from an RRSP invested for growth is soon replaced by the growth in the plan!

Every situation and provincial calculation is different, and requires careful planning with professional help to maximize the outcome for the individual and determine the effects of clawbacks and provincial assessments based on Net Income, but it is well worth considering. If withdrawing from an RRSP or RRIF to deposit to your fund, an optimal time to do that would be near the year end.

Here are some links which you may find helpful as you mull over the idea:

The Dynamic Charitable Giving Fund

Building Your Legacy with the MacKenzie Charitable Giving Fund

Canada Revenue Agency – Charitable donation tax credit calculator

Canada Revenue Agency – Charitable donation tax credit by province

Canada Revenue Agency – searchable database of registered charities

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The table below shows different asset combinations and the potential average yields that could be generated before fees. It then shows what the actual investor return or yield would be given different fee levels. Obviously, the higher the fees for given return, the lower the yield to you. Not as obvious is the fact that the vast majority of investors don’t know how this impacts them because most don’t know the level of fees they are paying for their investments.

Assumptions: (Pre-fee) annual returns of Equity, 10% and Bond, 5% Simplified Example: $100,000 capital

Basically, all variable investment products have a management fee. It is how revenues are generated in the investment industry. This fee is a cost you pay for the investment and, potentially, for other services, including, in most cases, advisor compensation. Often this fee is not transparent, in that you do not see it deducted from your gross returns. It is common for an investor to see only their net returns after fees have already been deducted. This is totally in line with the manner in which the securities regulators require they be quoted. I use the word “pay” because, although you likely don’t write a cheque, these fees are deducted from your account and your returns.

The range of fees on variable investments can run anywhere from about 0.25 per cent per annum to nearly 4 per cent per annum, depending on the investment option and advisor compensation. As stated above, these amounts are deducted from your overall returns.
One of the components in the fee structure is what is referred to as “imbedded compensation.” This is an amount paid to your advisor or the institution with whom you work. As a consumer what you need to know is:

• What is the total management expense ratio I am paying?
• What amount of the fee is for additional benefits or features of this investment?
• How much of this fee is for service and advice?
• What am I receiving from my advisor or institution for the fee I am paying?

The cost-to-benefit relationship relative to fees and advice/service is more transparent if your institution or advisor is actually adding a fee to an investment option where compensation is not imbedded. This is the usual practice where ETFs, pools or F-series mutual funds are used as the investment options.

Fees are a fact of investing. But you should be able to answer the four questions listed above, and the fees charged to you, in whatever manner they are charged, should be reasonable for what you are receiving in exchange for them.

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This is continued from our previous blog post on June 19th.

Additional Investment Considerations for Your Withdrawal Portfolio

There are a number of strategies and considerations that will be beneficial to you in obtaining the maximum benefit from your income-producing assets. Some of these have already been addressed, such as:

  • consolidate assets
  • consider income streams as well as assets
  • layer income in a specific order
  • provide the potential for some growth
  • adopt a model for income delivery

The above points will assist you to improve the efficiency with which your income is being created, reduce taxation and preserve your income-producing assets. Some of these actions are straightforward, simple and obvious, and yet I see many situations where they are still not being done properly.

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This is continued from our previous blog post on June 10th.

4.   If the equity selections provide investment returns that will allow you to take profits and replenish the Cash Wedge, it may make sense to renew the GICs or bonds. The objective is to maintain a multiple of income payments within the Cash Wedge by taking profits where and when appropriate from the other investments within the portfolio. You want to maintain it but not have too much money in this form.

5.   Any profits realized that do not need to be used to restore the Cash Wedge can be used to acquire additional units or positions in the investments that are flat or negative. If you have proper diversification in your investments, you should expect to have one or more of your asset classes/investments in a flat or negative position when your account is being reviewed. They should not all be performing in the same way at the same time. This is a sell-high, buy-low process that will likely result in higher returns over time. In addition, it will allow the portfolio to experience a lower degree of volatility. I’m not suggesting that you simply divest of good investments, but that you have a process through which you take profits and maintain them. It is important to note that all of this is done with an eye to maintaining the appropriate asset mix that was established at the outset.
6.   This process also affords you the opportunity to be selective in terms of which specific investments you use to create income.

These are all planning efficiencies that I will address and that you will see listed in the “Investment Considerations for Your Withdrawal Portfolio” section in Part 3 of this blog post.

Check back on June 30 for the continuing story of the Cash Wedge!

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The “Cash Wedge” is what I call the income delivery process I developed in 1993 and have been using successfully ever since. It helps to address the issues that you cannot control by allowing you to focus on those aspects over which you do have some influence.

A series of 3 blog posts throughout the month of June will be discussing this process.

The process
The Cash Wedge is a withdrawal model that incorporates a number of income and investment concepts within it, and it is used for both registered and nonregistered investments.

Here are the steps that make it function effectively.

  1. The first thing that needs to be established is the asset allocation (equity-to-fixed-income mix) that is appropriate for you. That is a discussion for you and your advisor. You can also find online questionnaires that will help you determine what the most appropriate asset mix is, given your objectives, tolerances and timeline. In the figure above, I have shown a 60 per cent equity, 40 per cent fixed-income allocation. For this explanation, let’s assume this is your account.
  2. Within the fixed-income portion of the portfolio, create a cash position equal to the income needed for the first 12 months. You will draw your income from this cash position. This is the source for your income because cash does not fluctuate. Also acquire a one-year and a two-year GIC or bond in order to create the source of income for years two and three. As they mature, simply move the proceeds to the cash account to replenish it and continue your income withdrawals. At the outset, this provides three years of guaranteed income. It could also be set up for two or four years, depending on your situation and your preferences. On this portfolio size, an annual withdrawal rate of about 5 per cent provides withdrawals of $3,000 per month, or $36,000 for the year.
  3. The initial cash amount of $36,000 and the GICs/bonds are part of the 40 per cent of the portfolio allocated to a fixed-income mandate. The two other fixed-income segments in the pie chart round out the 40 per cent. The 60 per cent equity component is shown as three separate positions, which could be Canadian equity, U.S. equity and international equity. You still want to have some diversification within specific asset classes.

Check back on June 19 for the continuing story of the Cash Wedge!

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Based on early research of actual stock market returns and retirement scenarios over the past 75 years, it was found that retirees who draw down no more than 4.2 per cent of their portfolio in the initial year and adjust that amount every year thereafter for inflation stand a greater chance that their money will outlive them.

The analysis also showed that retirees who draw down at a rate of 5 per cent a year (again, adjusted annually for inflation) run a 30 per cent chance of exhausting their income-producing assets.

This model assumes that retirees need a fully-indexed level of income all the way through their retirement, and I have found that this is inaccurate. An additional complication in looking at U.S. models is the inclusion of health-care costs. I want to emphasize that we do have health care – related costs in Canada, but not to the same degree as in the United States.

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  1. Don’t make the decision to retire without knowing that you have the assets you need to fund the lifestyle you seek. This is one of the prime functions of your blueprint. It can help you determine if it is feasible to do what you want on what you have. Retiring too early, with inadequate financial resources may free you from a work situation you are anxious to leave, but often results in a more stressful experience from which you cannot extract yourself.
  2. Your retirement is not going to look like Mom and Dad’s retirement. Having realistic expectations is one of the key factors in enjoying a fulfilling experience. Have you (and more importantly, you and your spouse) defined your expectations for what you want out of retirement and have you shared them with each other? You need to think through the design you want for your own retirement and have a blueprint drafted to address that design. Your blueprint will help you to get the most out of your time and your assets going forward.
  3. Your retirement lifestyle may involve working, for any one of a number of reasons. This may not necessarily be where you worked up to the point of retirement and may not even be connected to what you did through your working years.
  4. Remember that carrying debt into retirement is very different from the approach our parents took, but it is not uncommon for Boomers. You are not going to “burn in hell” for retiring with a loan or mortgage. But you do need to realize that servicing any indebtedness in retirement is going to require a commitment from retirement cash flow and the assets that create that cash flow.
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Have you ever been driving to a destination and found yourself wondering if you had enough fuel to complete the trip? It is a very unsettling and stressful feeling and does not make for an enjoyable journey, for either the driver or the passenger(s). This same emotional distress and discomfort underlies a retiree’s fear of running out of money.

The point is to ensure that you are making the decision to retire from a position of financial confidence and comfort. It’s critical to have a formal income plan, or blueprint, show what your assets can realistically be expected to provide in terms of sustainable cash flow. After all, it is your cash flow that will fund your lifestyle. Granted, there are many things that change as one moves through retirement. Hence the need for reviewing, fine-tuning and occasionally redoing the blueprint.

You can comfortably decide to retire if:

  • you have sufficient assets and benefits to create the income you need to provide the lifestyle you want, and
  • the income can be sustained throughout your retirement

You could consider retiring into a somewhat more conservative and less expensive lifestyle. This would require less cash flow and could help to extend the life of your income-producing assets such that you can retire now. Another option would be to still focus on your original lifestyle objectives and simply work longer to build up additional retirement assets. It really does come down to a personal assessment because every situation is unique.

Everyone (and every couple) has their own:

  • reasons for wanting to retire
  • lifestyle objectives
  • priorities and preferences
  • cash flow needs and time frame
  • income-producing assets and benefits to create income
  • family issues
  • state of health as they enter retirement

The factors listed above are exactly why you need to have a blueprint. It will allow you to design what you wish to do and understand the financing required to do it. From there it becomes a function of executing the plan and doing so in the most efficient manner possible.

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One change that occurs when you start drawing your retirement income is how tax is paid on the income. During your working years, tax is deducted by your employer and remitted on your behalf. You are left with your net take-home pay.

In retirement, however, that is a factor that you must look after yourself or in conjunction with your advisor or institution. And you will have several sources of income where this needs to be done. Direct remittance of tax is available on any form of income, including government retirement benefits.

It is important to approximate the total tax payable and deduct appropriate amounts from the various payments being made, especially in the first year of retirement. Failure to do this will result in a tax bill in the spring. If you have a non-registered investment account, money could be taken from it to pay the taxes due.

Some people face a situation where they have to pull money from RRSP accounts. Although this solves the problem of the current tax bill, it creates larger tax issues for the following year.

Direct remittance is particularly important in situations where retirement income begins mid-year, after several months of employment income has been received. It is likely that larger amounts will need to be remitted for the balance of that year.

Institutions holding and making payments to you from your registered income vehicles, such as your RRIF, LIF, LRIF, RLIF or PRIF, are required to withhold and remit taxes based on the level of payments made to you over the course of the year.

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Understanding the difference between a tax deduction and a tax credit will enable you and your advisor to apply strategies and employ financial tools to help you reduce the tax you pay on your retirement income.

Tax deductions are subtracted from total income to arrive at the net and taxable income figures. Any deduction serves to lower the net or taxable income figure. This has a positive effect on your income tax calculation since it will reduce tax at the highest marginal rate.

As such, the value of a tax deduction increases as your income increases.

Tax credits operate differently. Once calculated, the basic federal tax is reduced by federal tax credits, which include the personal credit, age and pension credits, dividend tax credit, spousal credit and medical expense credit. The resulting number is the federal tax payable. A credit is actually more beneficial than a deduction at lower income levels because it is a dollar-for-dollar reduction in tax payable at the lowest marginal rate.

There are two important tax credits that apply directly to your retirement income planning and your blueprint, the pension credit and the age credit. In retirement, when you are drawing your income from assets and benefits, few tax deductions are available unless you also have employment or rental income.

So tax credits become an even more valuable commodity. To lose or waste them needlessly, at any point through the Income Continuum, is extremely inefficient.

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