How to use your retirement accounts to replace your paycheque

One question advisors get all the time is, “How do I withdraw money when I retire?” The answer can be complicated, as successful savers have often taken advantage of the tax-deferral benefits of various accounts, including RRSPs, TFSAs and corporate investment accounts.

Although this article focuses on retirement, it is not about how much Canadians need to retire or what investments they should make each year. Instead, we outline a process to help decide how to withdraw money once a steady paycheque is no longer a part of one’s financial picture. By creating a structured approach to determine how to turn successful savings into lifestyle spending, anyone can make this process work regardless of age.

 

The process

Upon retirement, we strongly recommend having a detailed, custom financial plan. The plan should outline and answer key financial concerns, such as how much you can spend during your life, and it should also consider all factors and assumptions you and your advisor have agreed on. Once completed, the plan should be reviewed regularly. Most important, it must give you a detailed road map that enables annual monitoring to know whether or not you are on track.

 

At Mercer, many private wealth counsellors employ a program that outlines how much you should have in investments at the end of each year of your retirement. If you’re on track, we can discuss potential options to help your family flourish, such as charitable giving or helping kids and grandkids. And if you have less than what you need to fulfill your goals, we can recommend corrective action to get back on track. The six steps below outline the process we follow to help clients answer these complex and essential questions.

The process: Working years

Although this article is focused on spending in retirement, the process during your working years is similar but reversed. We cannot stress enough that working Canadians need to have a financial plan outlining what they want retirement to look like and what they need to save each year to get there.

The steps

 

1. What do you need to live on this year?

This is what you expect to spend and is based on your financial plan. But keep in mind that you cannot predict every event, so you’ll need to discuss with your advisor how best to allow for unplanned expenses that may come up.

 

2. What are my fixed sources of income?

When you retire, there are many sources of income you cannot change. These create a floor of taxable income. For instance, although you can somewhat control the timing, the Canada Pension Plan, Old Age Security and minimum registered retirement income fund (RRIF) withdrawals must happen at certain ages.

 

RRIF withdrawals are perhaps the most well-known example. Canadians can put off taking registered retirement savings plan (RRSP) withdrawals, but the year they reach age 71, they must convert the RRSP to a RRIF and take out a minimum annual percentage.

 

In addition to these types of withdrawals, there may be other amounts from company pensions or personal pension plans that increase a retiree’s taxable income floor.


3. What about my variable sources of income?

The income sources outlined in step 2 above are the obvious sources of fixed income, but you may need to consider other income sources.

 

What about the investment income earned in my taxable, non-registered investment account?

 

Tax must be paid on dividends and interest earned in this account regardless of whether you spend or reinvest. Many long-term investors reinvest within their non-registered accounts automatically and miss including this income in their tax planning.

What happens if I don’t take this holistic view to managing accounts and withdrawals?

 

Although investors may have to estimate how much investment income will be earned in their nonregistered accounts, this is a crucial step that should not be missed. Not factoring this information into the equation may lead retirees to take out more assets from their RRSPs or RRIFs, thereby increasing their taxable income.

 

Choosing to draw money out of an investment account instead of a RRIF account can lead to a better after-tax outcome. Remember, in this scenario, you are not taking out more cash overall, you’re just taking it from different sources in a more tax-effective manner. The amount you have overall in investments is the same; it’s just in different accounts.

 

Although this idea is not unique, we believe successful savers should always integrate their retirement income planning with overall tax planning. This step enables investors to improve their tax efficiency and create a better after-tax situation.

4. If my spending needs are higher than the cash flow from step 2 above, how do I get the additional money I need tax-efficiently?

In steps 2 and 3, we worked to identify sources of income. In step 4, we reconcile these sources with the spending needs outlined in step 1. The key to step 4 is getting the necessary cash flow as tax-efficiently as possible.

As an example, let us assume a retiree needs $70,000 annually to live and receives the following as fixed payments:

 

Annual spending needs: 

$70,000

CPP 

-$11,500

OAS 

-$4,500

Minimum RRIF payments: 

-$30,000

Shortfall:

($24,000)

What are my options to make up for this shortfall?

Here are some common solutions:

 

  • Take more RRIF payments. These are fully taxable and may impact OAS payments. 
  • Take investment income out of your nonregistered accounts. With adequate planning, this can be a good source of income, regardless of whether the income is earned in a holding company or personal trading account.
  • Redeem capital out of your savings or your holding company. Each has different tax attributes. Taking your starting capital out of personal non-registered investment accounts is taxfree. Since taking capital out of a holding company usually involves paying yourself a dividend, it is taxable in the year you receive it. As noted above, additional income may affect OAS payments.
  • Draw on a line of credit. It may make more sense to use a line of credit (at low rates) rather than other funds that are heavily taxed.
  • TFSA. Withdrawals from tax-free savings accounts can be taken without tax.

The steps: Working-age business owners

This thought process can help working-age business owners as well. For example, successful business owners may have significant savings in holding companies, separate from their active businesses. They can use similar comparative financial planning techniques to withdraw assets to live in a way that maximizes their after-tax assets. Two different scenarios can highlight the benefits of this planning:

 

A. The owner takes a salary from his active company for his lifestyle needs. But at the same time, his holding company pays tax on investment income at a high tax rate. In this scenario, more tax goes to the government (although some of this tax may be refundable in the future).

 

B. Alternatively, an owner in a similar situation can take a smaller salary from her active company and a small dividend from her holding company. In this case, the owner still gets the income she needs, but the overall tax paid to the government is lower since the holding company pays less tax.

Understanding tax rates

Maximum personal tax rates (using Ontario as of 2021)

 

  • Regular income, such as salary: 53.53%
  • Eligible dividends, mainly via publicly traded Canadian companies: 39.34%
  • Ineligible dividends, mainly via private Canadian companies: 47.74%
  • Capital gains, from selling an asset for more than you paid: 26.77%

Notes on personal rates and tax planning:

 

  • Professional tax advice is recommended. Rates may change in the future. The examples outlined above are not all-inclusive. Many income attributes may affect these rates.
  • Ensuring some taxable income during retirement can be advantageous, as it enables the use of lower marginal rates of tax that apply at lower incomes, credits for medical expenses and charitable donations, and other basic deductions. All advisors have their own income values at which they feel the tax benefits are no longer as valuable, but for our clients, we look to have taxable income of around $60,000 plus or minus a bit. Again, everyone is different, and because there may be other factors to consider, we recommend seeking customized advice.

Maximum Canadian small business rates (using Ontario as of 2021)

 

  • Active income to $500,000: 12.2%
  • Active income over $500,000: 26.50%
  • Investment income — the top rate, but varies for certain types of income: 50.17%

Notes on corporate tax rates:

 

  • Integration: Tax policy is built on the concept of integration. The logic is that the ultimate tax that is owed should be the same regardless of whether or not it flows through a corporation. If integration did not exist, the tax cost of flowing money through corporations would be larger. Due to many tax changes over the years, however, integration is no longer perfect. This is a key concept and something you should discuss with your accountant and financial advisors.
  • Refundable dividends: Some of these corporate tax amounts are refundable when dividends are paid out to shareholders. When a dividend is paid to a shareholder, the shareholder pays a tax, and the company gets tax back. We hope to talk more about this in a future article, but in the meantime, if you have a corporation, make this a point of discussion at your next meeting.

 

How do I know which accounts to withdraw from first?

 

Withdrawing from accounts can have short- and long-term tax implications that depend on an investor’s personal tax rate now and in the future. As a result, estimating these effects can be complex, and you should seek professional accounting and financial advice.

 

However, if you are at the highest marginal tax bracket and own a corporation or holding company, an initial withdrawal plan might start with this ordering:

 

  • Capital and income from non-registered accounts and tax-free dividends from the corporation 
  • Lines of credit 
  • TFSAs 
  • Dividends from the corporations
  • Remaining RRSP/RRIF/LIF

As you can see, you may need the help of your accountant and private wealth counsellor to coordinate tax consequences from these various accounts and customize the order for your situation and goals. However, using this holistic planning approach to spending can improve your overall tax situation.

 

5. Monitor your cash flow and income sources

Most people set their budgets for the year, and that is their plan. However, as the year continues, changing circumstances may require fine-tuning your budget. For OAS, CPP and minimum RRIF payments, you know what they are precisely because these amounts are set once per year. Although there may be some minor cost-of-living adjustments for OAS and CPP, these are small.

 

For other sources of income, such as investment income earned in non-registered accounts or any other income that comes your way, updating your estimates partway through the year and making any adjustments can be valuable tax planning.

 

6. Repeat the process

If you take these steps throughout your retirement life, you will not only have a good handle on where your money comes from and goes, but you’ll have a real understanding of your overall financial health. It will also reduce potential stress along the way and keep your financial plan front and center.

 

We hope this paper has helped to kindle your thinking on spending during retirement. Everyone’s situation is different, and some of these strategies come with caveats and require complex calculations. Please reach out to your private wealth counsellor for help and advice. Although no one can predict exactly what will happen in the future, if you have a plan and a financial roadmap, you can handle the twists and turns that come your way.

Lloyd Wright, CA, CPA
Lloyd Wright, CA, CPA
Wealth Planning Consultant,
Mercer Private Wealth

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