One question I often get is whether you should invest in an RRSP when you are close to retirement. Investing in a Registered Retirement Savings Plan (RRSP) near retirement can be a good strategy, but it depends on several factors. Here are some key considerations to help you decide:
Benefits of Investing in an RRSP Close to Retirement
- Tax Deductions: Contributions to an RRSP are tax-deductible, which can lower your taxable income for the year you make the contribution. This is particularly advantageous if you are still earning a high income and expect to be in a lower tax bracket in retirement.
- Tax-Deferred Growth: The money invested in an RRSP grows tax-deferred, meaning you won’t pay taxes on the investment gains until you withdraw the funds. This allows your investments to grow faster compared to a taxable account.
- Income Smoothing: If you expect your income to drop significantly in retirement, contributing to an RRSP now can help smooth your income over time. You get the tax deduction now, and you’ll pay taxes on the withdrawals when you’re likely in a lower tax bracket.
Considerations and Potential Drawbacks
- Withdrawal Rules: RRSP withdrawals are fully taxable as income. If you need to withdraw the funds shortly after contributing, you might not get the full benefit of tax-deferred growth. Also, large withdrawals can push you into a higher tax bracket.
- Age Limits: You must convert your RRSP to a Registered Retirement Income Fund (RRIF) or an annuity by the end of the year you turn 71. This means mandatory minimum withdrawals starting the following year, which will be taxed as income.
- Other Retirement Accounts: Consider your overall retirement plan, including other accounts like a Tax-Free Savings Account (TFSA) or a pension plan. In some cases, it might be more beneficial to invest in a TFSA, as withdrawals from a TFSA are tax-free and do not affect your income-tested benefits.
- Tax Bracket Considerations: If you expect to be in a higher tax bracket in retirement due to other sources of income (like pensions or rental income), contributing to an RRSP might not be as advantageous.
Example Scenario
Suppose you are 60 years old, still working, and earning a high income. You plan to retire at 65, and you expect your income to drop significantly once you retire. Contributing to an RRSP now could provide immediate tax relief and allow your investments to grow tax-deferred. When you start withdrawing the funds in retirement, you’ll likely be in a lower tax bracket, reducing the overall tax burden.
Signs You Might Have Too Much in Your RRSP
- High Mandatory RRIF Withdrawals: After converting your RRSP to a RRIF at age 71, the mandatory minimum withdrawals might push you into a higher tax bracket, resulting in a significant tax burden.
- Impact on Government Benefits: Large RRIF withdrawals can increase your taxable income, potentially triggering clawbacks on government benefits like Old Age Security (OAS) or reducing your eligibility for the Guaranteed Income Supplement (GIS).
- Limited Flexibility: Having most of your retirement savings in an RRSP might limit your flexibility in managing taxable income. Withdrawals from an RRSP or RRIF are fully taxable, which can be less efficient compared to tax-free withdrawals from a TFSA or preferential tax treatment of capital gains in non-registered accounts.
- Estate Planning Concerns: If you have significant RRSP/RRIF balances at death, these amounts are fully taxable unless transferred to a spouse or a financially dependent child with a disability. This could lead to a substantial tax liability for your estate.
Managing your retirement savings effectively:
If you already have a substantial amount of money in your RRSP, there are several strategies you can consider to manage your retirement savings effectively:
Maximize Tax-Efficient Withdrawals
- Strategic Withdrawals: Plan your withdrawals to minimize taxes. Consider withdrawing funds during years when your income is lower to take advantage of lower tax brackets.
- Early Withdrawals: If you retire early, you might start withdrawing from your RRSP before you have to convert it to an RRIF. This can help spread the tax burden over more years.
RRIF Conversion Strategies
- Mandatory Withdrawals: Remember that you must convert your RRSP to an RRIF by the end of the year you turn 71. RRIFs have mandatory minimum withdrawals, which are fully taxable. Plan your RRSP withdrawals and conversions to manage your tax bracket.
- Partial Conversions: Consider converting portions of your RRSP to an RRIF gradually, starting as early as 65. This can help manage the tax impact by spreading out withdrawals over several years.
Splitting Income with a Spouse
- Spousal RRSP: If you have a younger spouse, contributing to a spousal RRSP can help split income in retirement. Your spouse can withdraw from the spousal RRSP at their lower tax rate.
- Pension Income Splitting: After 65, you can split up to 50% of your eligible pension income (including RRIF withdrawals) with your spouse. This can reduce your overall family tax burden.
Diversifying with Other Accounts
- TFSA Contributions: Consider maximizing your Tax-Free Savings Account (TFSA) contributions. Withdrawals from a TFSA are tax-free and do not affect your income-tested benefits.
- Non-Registered Investments: Invest in non-registered accounts for additional savings. While these accounts do not have tax advantages on contributions, you can benefit from capital gains and dividend tax rates, which are often lower than regular income tax rates.
Consider the Impact on Government Benefits
- Old Age Security (OAS) Clawback: High RRIF withdrawals can increase your net income, potentially triggering the OAS clawback. Managing your withdrawals to keep your income below the OAS recovery threshold can help avoid this.
- Guaranteed Income Supplement (GIS): If you qualify for GIS, large RRSP or RRIF withdrawals can reduce or eliminate your GIS benefits. Plan withdrawals carefully if you depend on GIS.
Charitable Donations
- Charitable Giving: If you are charitably inclined, consider donating appreciated securities from your non-registered accounts. This can reduce your taxable income and help manage your overall tax burden.
Work with a Financial Planner
Example Scenario
Suppose you are 68 years old with a substantial RRSP balance, and you are concerned about the tax implications of mandatory RRIF withdrawals starting at 71. You could:
- Start Early Withdrawals: Begin withdrawing from your RRSP now to take advantage of lower tax brackets before converting to a RRIF.
- Partial Conversion: Gradually convert your RRSP to a RRIF over the next few years to spread out taxable income.
- Split Income: Utilize pension income splitting with your spouse if they are in a lower tax bracket.
- Maximize TFSA: Contribute to your TFSA and use it for tax-free withdrawals in retirement.
- Manage OAS Clawback: Plan withdrawals to keep your income below the OAS recovery threshold.
Assessing Your Situation
- Calculate Projected Withdrawals: Estimate the required minimum withdrawals from your RRIF based on your expected balance at age 71. Determine if these withdrawals will push you into a higher tax bracket.
- Evaluate the Impact on Government Benefits: Assess how RRIF withdrawals affect your OAS and GIS eligibility. Use current OAS clawback and GIS eligibility thresholds to see if your withdrawals will exceed these limits.
- Diversify Retirement Savings: If you are close to or already retired, consider the balance between your RRSP, TFSA, and non-registered accounts. Aim for a diversified approach that allows more tax-efficient withdrawals.
- Plan for Tax Efficiency: Consider strategies to manage your taxable income, such as making strategic withdrawals from your RRSP before age 71 or transferring funds to a spousal RRSP if applicable. Maximize contributions to your TFSA, as withdrawals are tax-free and do not impact your income-tested benefits.
Managing your RRSP effectively as you approach retirement can help optimize your tax situation and ensure a more comfortable retirement.
Consulting with a financial planner can provide personalized strategies tailored to your circumstances. You might also consider purchasing “The Art of Retirement.”
