When to avoid RRSPs

Many clients assume money put into RRSPs will stay there until retirement. That’s the goal, but life isn’t always so tidy.

People who blindly contribute, without thinking about whether they’ll need the cash before turning 65, are doing themselves a disservice because withdrawals trigger steep withholding tax:

• 10% on amounts up to $5,000;
• 20% on amounts from $5,000 to $15,000; and
• 30% on amounts over $15,000 (note, rates are different in Quebec).

Worse, CRA will tax your client at her marginal rate if it’s higher. So, if she pulls $35,000 from her RRSP to pay for her daughter’s wedding, it’s taxed as income.

Many now opt for TFSAs or non-registered accounts to fund these short-term cash needs. But these aren’t the only times clients should steer clear of RRSPs. Here are four more.

1. When on the cusp of retirement

Say a client has a dip in income when he’s five to 10 years from retirement. It could be due to health issues, stepping out of the workforce to care for a parent, or just a slow year if he’s paid on commission.

If this puts him in a lower bracket than in retirement, and if he expects his retirement income will cause OAS clawback, he should consider taking money out of the RRSP now and investing it in a non-registered account (assuming TFSAs are maxed out).

Clawbacks begin when income’s above $71,592; and OAS distributions are completely nixed when income hits $115,716, notes Cynthia Caskey, a vice-president and portfolio manager at TD Wealth Private Investment Advice in Toronto.

She says these clients should consider corporate-class mutual funds in non-registered accounts. “It’s a taxable account, but because of the deferred nature of a lot of the growth it’s a great option for controlling when and if [he] harvests those gains. It’s tax-efficient for someone who’s trying to stay under the OAS ceiling.”

This strategy essentially produces tax alpha. “People are always talking about MERs, but if you can help someone keep 20% to 30% more in his pocket for a number of years, and it continues to compound, the MERs pale in comparison.” Caskey notes an additional advantage of corporate class: tax-deferred switching between funds, which isn’t available with individual securities or ETFs.

Stephen Reichenfeld, a Calgary-based private wealth counsellor at Fiduciary Trust Canada, says clients who take early retirement may also benefit from RRSP withdrawals. One such client, whose spouse continues to work, withdraws about $12,000 a year.

Since the client isn’t working, her money comes out virtually tax-free.

“They are trying to drain as much money as they can out of her RRSP over the next 13 years,” Reichenfeld says. In total, the couple will pull out about $156,000, and use it to catch up on TFSA room and continue with ongoing contributions. What’s left over will go into a non-registered account.

If they leave the money in the RRSP, total RRIF payments will reach about $1.3 million. Reducing the principal now will mean a smaller tax bill later on.

“Clients in their mid- to-late-50s who are no longer employed should take a good look at this option,” says Reichenfeld.

But even if they’re still employed, RRSP contributions may be a mistake, says Matthew Ardrey, consultant and manager, financial planning at T.E. Wealth in Toronto.

Take a case where a client’s semi-retired and has $500,000 in RRSPs, plus a pension. She retired early from her automaker employer of 30 years; to alleviate boredom, she works part-time at Home Depot.

Continuing her RRSP contributions yields a 22% tax deduction today; but once she starts drawing down those savings, she’ll be taxed upwards of 40%. So, rather than adding to the RRSP, she should use TFSA room or non-registered accounts.

“There’s no advantage to a non-registered account over a TFSA,” says Ardrey, “but a non-registered account can have an advantage over an RRSP.”

2. When implementing a capital gains strategy

Wealthy investors should consider non-registered accounts instead of RRSPs to build tax-efficient portfolios from individually purchased stocks, Caskey suggests.

Money coming out of RRSPs is taxed at the client’s top marginal rate. This removes the tax advantage of capital gains.

Not so with a non-registered account.

The portfolio should be built with blue-chip stocks, Caskey says, and these clients must have a minimum 10-year horizon. This gives unrealized gains time to compound.

Since diversification across sectors is critical, the clients need to be wealthy since smaller investors don’t have the financial wherewithal to do so with individual stocks.

Caskey flags one potential pitfall. Say a stock loses its blue-chip status, as happened with Yellow Pages following its failure to migrate to the web. The firm’s long-term outlook became less promising, so it made sense to sell.

But clients may resist because they want to avoid tax. “If they’re not willing to bite the bullet on taxes,” she says, “it can lead to a big spill on investment returns.” In some cases, those losses can offset gains in the other blue chips through tax-loss harvesting.

She says advisors should be in frequent contact with their research teams to get independent views on changes in a stock’s performance. “[Their] goal is to help clients distinguish between a temporary setback and a permanent impairment.”

3. When owning a business

Wealthy business owners or clients with professional corporations, such as lawyers or accountants, are sometimes better off not taking a salary and not contributing to an RRSP, says Michael Nairne, president and CIO at Tacita Capital in Toronto.

Earlier in their careers, it may have made sense to save through an RRSP. But now these clients make lots of money, and will have investable assets beyond what they contribute to RRSPs. Clients may also start receiving income from inheritances.

Nairne says when this income can cover essential and lifestyle spending, it may be time to stop taking a salary and investing in the RRSP. A more tax-efficient alternative could be investing within the corporation using the active business income it generates.

That income is subject to the small-business deduction, resulting in a 15.5% tax rate (for the first $500,000 in Ontario), provided it stays within the corporation. “For a dollar earned she gets to invest 84.5 cents, and her strategy should be to build unrealized capital gains,” says Nairne, adding broader-market ETFs are well-suited to this objective.

The client has to pay tax on investment returns, but if a big chunk of her gains are unrealized, she can defer tax until the death of the second spouse. “She can take investment income if she wants,” says Nairne, “but the strategy’s geared towards long-term family wealth creation or retirement funding.”

Advisors have to run projections and compare likely outcomes of both approaches. But for many clients, “declaring a salary every year on top of their already material investment income, and then making RRSP contributions, creates much more tax drag than ceasing the RRSP contribution and then building wealth within the corporation.”

4. When buying a first home

Conventional wisdom says clients saving for a first home should do so in an RRSP and take advantage of the Home Buyers’ Plan (HBP). But not everyone agrees.

The HBP allows your client to withdraw up to $25,000 from her RRSP tax-free. If her spouse’s RRSP contains enough additional cash, they can take out $50,000. Contributions must be in the account for at least 90 days before they’re used for the HBP, and the money has to be repaid. The full amount’s due in 15 years. Payments on a $25,000 withdrawal are $1,667 a year or $140 a month; for $50,000, it’s $3,333 a year or $280 a month.

New expenses tend to pile up when couples buy a first home, notes Ardrey. Payments for new furniture and appliances can make that $140 or $280 a lot more difficult to set aside. Adding car payments or costs associated with children makes it even harder.

“If they fail to make a repayment in a year, the amount…will be included in [their] income for that year and taxed at their marginal rate,” Ardrey explains. “Any repayments will not be eligible for a deduction.”

This lack of flexibility is why he suggests using a TFSA to save for a first home. Contributions are with after-tax dollars, but the impact is typically less for first-time homebuyers because they’re in lower brackets. And they don’t have to repay the money.