What’s the most tax-efficient retirement income source?

As the number of retirement income options grows, clients want to know which is most tax-efficient. But the answer depends on many factors.

Tax efficiency factors

Tax efficiency for retirement income is not a static concept. There are several contributing factors:

• Age and marital status: If one’s age, combined with marital status, meets certain criteria, sources known as “eligible pension income” can be split between spouses (this includes married and common-law partners). Single individuals will not have the option of income splitting these sources of income. Eligibility for certain tax credits is also determined by age.
• Investment income from a taxable account: Interest, foreign income, eligible Canadian dividends and capital gains are all taxed differently, and return of capital is tax-free.
• Registered account type: Withdrawals from an RRSP or RRIF are fully taxable income, regardless of the investments held within such accounts. Further, RRIFs have mandatory minimum withdrawals that must be taken as taxable income. RRSPs have no such requirements. Withdrawals from TFSAs are completely tax-free and can be re-contributed in future calendar years.
• Income source: Income from company pension plans and CPP, for example, can provide tax benefits when combined with other factors such as marital status and age.

Ranking tax efficiency is complicated

Let’s review four scenarios. The first two will focus on two households of 62-year-old Manitoba residents (Zack, a single person, and Simon and Jeannie, a married couple). Each household has the same pre-tax income and income sources (see Table 1). In the married household, only Simon worked and therefore only he is eligible for CPP. Further, Simon is the sole owner of the taxable investment portfolio and the income from the portfolio is taxable to him.

Table 1: Pre-tax income

Which sources are most tax efficient for each household?

Zack

• Eligible Canadian dividends, thanks to the $1,588 combined federal and provincial dividend tax credits.
• Employer pension income. It’s fully taxable, but also eligible for the federal and provincial pension income amount, which results in a combined tax credit of $408.
• RRSP/RRIF, CPP and interest/foreign dividends. These sources are fully taxable with no additional savings. While foreign dividends are eligible for foreign tax credits against Canadian income taxes paid, the foreign tax withheld usually can’t be avoided, resulting in the same liability as if the income were fully taxable in Canada.

Simon and Jeannie:

• Eligible Canadian dividends.
• Employer pension income, which can be split between the two spouses; both receive the pension income amount, which results in a $408 tax credit per spouse. They paid less tax than Zack on this income because of the pension income splitting rules.
• CPP. By applying for pension sharing, our couple can share up to 50% of the CPP income and save more tax than Zack.
• RRSP/RRIF and interest/foreign dividends. These sources are fully taxable and ineligible for income splitting.

Changing only the marital status variable led to two retirement income sources (employer pension and CPP) being more efficient for Simon and Jeannie than for Zack.

Marital status also impacted each household’s net income. Zack paid $9,374 in taxes, making his net income $40,626. Simon and Jeannie paid $5,521 in taxes, making their net income $44,479.

For our next comparison, we will age our two households: they are now all 68-year-old residents of Manitoba. All income sources remain the same but everyone now receives OAS. To ensure each household has the same pre-tax income, Zack will make annual withdrawals from his taxable investments to offset the second OAS pension in the married household (see Table 2).

Table 2: Pre-tax income with OAS

Which sources are most efficient this time? Let’s evaluate Zack’s income first.

• Systematic withdrawal plan (SWP). To reach $64,000 of pre-tax income, Zack sells $7,000 of taxable investments. The withdrawal triggers a capital gain of $350 ($175 of which is taxable). While this is the most tax-efficient income source (and more efficient than a second OAS pension), it erodes the capital in his taxable investment account and may reduce future eligible dividends, interest and foreign dividends.
• Eligible Canadian dividends.
• Employer pension, which provides $408 in tax savings.
• RRIF, CPP, OAS and interest/foreign dividends, which are fully taxable. While RRIF withdrawals are eligible pension income for those 65 or older, there are no additional tax savings because the pension income amount is maximized by the employer pension.

And now Simon and Jeannie:

• Eligible Canadian dividends, thanks to the dividend tax credit.
• Employer pension, thanks to the ability to split and the pension income amount.
• RRIF income. Once Canadians reach age 65, RRIF income, like an employer pension, can be split between spouses.
• CPP, since Simon and Jeannie can pension share CPP to improve its tax efficiency.
• OAS. Since the OAS pension amount is determined by residency, it is possible to receive the maximum (or close to it) without working in Canada or making contributions. As a result, both spouses may be eligible for the same amount of OAS.
• Interest/foreign dividends.

The scenarios show how both age and marital status impact the tax efficiency of retirement income sources. Zack’s net income was $52,814 and he paid $11,186 in taxes. For Simon and Jeannie, net income was $57,738 and they paid $6,262 in taxes. Despite the tax efficiency of the SWP, Zack still had less net income than Simon and Jeannie, who used the additional income splitting options available at age 65.

Evidently, there are several factors that influence the tax efficiency of various retirement income sources. Advisors must provide personal answers to the question of which income sources are most tax efficient, and create a customized retirement income plan for each client.

Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant, Tax, Retirement & Estate Planning Services, Retail Markets at Manulife. Reach him at Curtis_Davis@manulife.com.

Curtis Davis

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.