Maturing an RRSP – and saving on taxes

If you have clients who are turning 71 this year and are in good health, by all means congratulate them. Even in an era of growing life expectancy, 71 is a notable age. It is also an important marker in a person’s financial lifetime because this is the age at which individuals are required by law to mature their registered retirement savings plans.

In this column I am going to use the example of an investor – we’ll call him Allen Smith – who has continued to work until age 71, a plausible scenario in these uncertain times. I’ll discuss his RRSP conversion options in general terms. Then, I am going to suggest an RRSP final year strategy for our Mr. Smith that can help him, and by extension, your clients, take advantage of additional RRSP room while generating tax savings.

Four ways to wind down an RRSP

Allen Smith turned 71 in July and he now has until December 31 to mature his RRSP. He can do it any one of four ways, although the alternatives have pluses and minuses. Here are his choices:

• Lump sum withdrawal: Allen can withdraw all the funds in his RRSP and have the money taxed as ordinary income. The financial institution that handles his affairs will withhold tax on the gross proceeds, which he will report on his income tax return for the year as ordinary income and calculate the actual tax thereon. Depending on the size of the RRSP and on any other income Allen earns in this transition year, this may be the most tax inefficient method to mature an RRSP since Allen could see a lot of his hard-earned savings disappear in taxes. To add insult to injury, not a penny of these savings will be eligible for the pension tax credit. Clearly, for most investors this is the least desirable choice.
• Allen can use his RRSP proceeds to purchase an annuity. An annuity is an insurance contract that will provide him with steady income over its life, taxes will be levied as payments are received, and as much as $2,000 a year of his payments will qualify for the pension income tax credit. Allen can choose one of three kinds of annuity: term certain, which guarantees payments to him or his estate for a fixed period; single life, payable as long as he lives; and joint and last survivor life, which will provide payments for Allen’s and his spouse’s lifetimes. The option he chooses will determine the amount he receives each month. Allen’s personal circumstances, as well as the course of interest rates will also help determine how much he should allocate to annuities versus a more flexible registered retirement income fund.
• Allen can convert his RRSP into Registered Retirement Income Fund (RRIF), maintaining the ability to manage investment of the funds in diverse securities while being taxed only on the amount he draws down in the course of a year. As with an annuity, up to $2,000 of the annual payments from a RRIF may be exempt thanks to the pension income tax credit. A potential drawback to a RRIF is that the law requires minimum annual withdrawals, ranging from 7.38% of the total in the fund at age 71 to a maximum of 20% at age 94. There is a way to reduce the minimum rate. Should Allen have a younger spouse, he can choose to base his minimum annual withdrawal on her age, thus reducing the percentage he draws down.
• If Allen was formerly a member of a company’s registered pension plan, he may have transferred the commuted value of his plan to a locked-in retirement account (LIRA) or a locked-in RSP (LRSP). His main conversion options for his LIRA or LRSP at age 71 are to move the proceeds to a life annuity, a life income fund (LIF) or a locked-in retirement income fund (LRIF). An overview of the annuity option is provided above. LIFs and LRIFs are somewhat similar to RRIFs in terms of taxation, but have restrictions, such as maximum withdrawal levels, that make them more complicated.

As Allen’s financial advisor, you might recommend that he matures his RRSP using some combination of the methods mentioned above, though one would usually not recommend an outright withdrawal at age 71 because of the tax hit. You might, however, consider how a RRIF would help him retain control over his invested funds, or, if he mainly interested in a reliable, lifetime income stream, how an annuity might be a viable part of the solution.

Knowing your client pays dividends

The more you know about Allen’s situation, the more you may be able to help him. It turns out he retired from a career in engineering in his mid-sixties, but still works as a self-employed consultant. He has yet to touch his RRSP savings, relying instead on his consulting income as well as non-registered savings. He has maxed out his RRSP contribution every year.

Now that he’s turned 71, he has a problem. He earned income in 2010, which means he will generate RRSP contribution room for 2011. But because of his age, he has to mature his RRSP by December 31, 2010. Future RRSP contributions are ruled out, since RRSP contributions cannot be made to an annuity, RRIF, LIF or LRIF.

Saving room, saving on taxes

You could advise a strategy that would allow Allen to not only make use of his additional contribution room but save on taxes, not a bad way to celebrate turning 71. Here’s how it works. Allen has already contributed the maximum amount for 2010, but you suggest that he makes his 2011 RRSP contribution in December 2010. The first $2,000 of this “over-contribution” carries no penalty; the rest will incur a penalty of 1% per month. The tax savings from the 2011 RRSP deduction will usually more than compensate for the 1% penalty.

When you apply numbers to the example, the benefits are clearer. Say, for example in 2010, Allen has self-employment income of $75,000 and a 35% marginal tax rate, leaving him with $13,500 ($75,000 X 18%) in new RRSP contribution room for 2011. In December 2010, he makes a $13,500 RRSP contribution and then matures the plan. After deducting an allowable over-contribution of $2,000, Allen is left with an $11,500 over-contribution that will incur a 1% penalty for one month or $115. On January 1, 2011, Allen will have $13,500 in new RRSP contribution room and will be able to deduct the contribution he made in December 2010 against his 2011 income. Assuming that in 2011, Allen maintains a 35% marginal tax rate, he stands to make a tax saving on his RRSP contribution of $4,725 ($13,500 X 35%). When you deduct the $115 penalty he paid on the RRSP over-contribution from his gross tax saving of $4,725 on the RRSP deduction, his net tax saving will be $4,610.

Helping clients two ways

As with any strategy, there are caveats. For example, our Allen Smith would be well advised to self-assess and remit the penalty, since Canada Revenue Agency will likely assess the penalty and charge interest. And it’s not a one-size-fits-all strategy. If a client were to simply mature the RRSP by cashing out, it won’t work. What does work, however, is being informative and helpful to clients as they mature their RRSPs. As you lay out the options to provide them with financial security through their 70s and beyond, there could also be opportunities for meaningful tax savings, a double win.

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Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC .

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