Minimize RRSP tax with proper planning

When RRSPs were introduced in 1957, no one expected to see Canada’s investing landscape become as diverse as it has. With T-Series funds, corporate class options and now the tax-free savings account —not to mention all the various tax strategies that have come into play over the last 50 years —helping a client ease into retirement isn’t so easy anymore.

At the Knowledge Bureau’s recent Distinguished Advisor Conference, retirement planning was a hot topic, with several industry heavyweights giving their opinions on how to plan properly in today’s complicated investing world.

Richard Croft, an investment advisor specializing in portfolio construction, and one of the conference’s speakers, is especially excited about the TFSA, to which anyone over 18 can contribute, starting January 2.

“The TFSA is going to be an excellent tool for clients moving toward their plans for retirement,” he says. “It’s one of those great gifts from the government.”

While no one argues that investing $5,000 a year tax free in an investment account is a bad thing, there is a debate among advisors on how to use this new option in conjunction with, or instead of, an RRSP.

Croft says high-net-worth clients should keep using the RRSP and get a tax deduction, but consider adding money to a TFSA too, since “it’s not going to make or break you one way or the other.”

For high-net-worth clients close to retirement, Croft says they should use the TFSA “very aggressively and try to shoot the lights out.”

“A high-net-worth person who is only putting in $5,000 and doesn’t have a whole lot of time to compound growth because of age should be more aggressive than the 20-year-old who’s just starting out and has years of compounding inside these things,” he says. “It’s the opposite way of looking at investments —you tend to get more conservative as you get older —but with this one you might want to get more aggressive.”

If your client isn’t in the top tax bracket, or has a job with a pension, a TFSA might make more sense. Croft says police officers, for instance, shouldn’t pay into an RRSP. “They should use a TFSA and call it a day,” he says. “The RRSP wouldn’t get that big a break, because they have a pension. If there’s extra money they can top up an RRSP.”

A TFSA is also more prudent in a worst-case-scenario situation. If someone has to pull out significant amounts of money from an RRSP all at once, the person’s government benefits can be affected. TFSAs won’t affect OAS or GIS payments. “RRSPs don’t make sense anymore in this situation,” he explains.

Part of the reason why RRSPs might not seem as relevant to some as they once were is that advisors and clients have found a flaw in the system.

Alan Rowell, founder of The Accounting Place, says people have been taught to “defer, defer, defer” as much tax as possible by contributing to a registered savings plan. This means contributions have been building up, in some cases, for 30 years or longer. The problem is that people can’t withdraw their money over the same length of time.

“A client isn’t taking out 30 years plus growth,” he says. “Under a RIFF calculation, they’re required to take their money out in 19 years. Anyone with $800,000 of RRSP contributions is going to be adding $42,000 to their tax return.”

The original idea behind the RRSP was for Canadians to contribute money during their working years and get a tax deduction at a higher marginal rate. When they pull their money out, and are forced to pay tax, the payments will be based on a lower tax bracket since the client will be making less money in retirement.

However, Rowell says that, today, many baby boomers have pensions and non-registered investments. “RRSPs are almost at the point where in some cases they’re not required, but people are being forced to withdraw money from them,” he says.

Like Croft, Rowell is excited about the TFSA. He says, enthusiastically, “Everyone should be opening one and everyone should max it. It should be automatic for all advisors and investors.”

He’s especially wide-eyed about the tax-free part of the TFSA. He says if someone runs into trouble, such as an unplanned medical emergency, that person can remove money from the tax-free savings account without worrying about being hit with a high tax bill. But if the client needs to pull out $20,000 from an RRSP, “they’ll have to take out $30,000” and could end up paying about a third of that to the government.

Rowell’s not advocating that a TFSA should be used over an RRSP —and most retirees have an RRSP anyway, so there isn’t much of a choice. Instead, he thinks advisors should pay more attention to tax efficient strategies to minimize how much of client’s cash goes to Ottawa.

“If you had someone who was in an interest-bearing investment, let’s say getting 5% on $200,000, they’d get $10,000 in interest,” says Rowell. “By the time they pay tax at a 45% marginal rate, it brings it down to $5,500. The return on investment would only be 2.75%. If you put the $200,000 in an eligible dividend investment, you’d only need a return of 3.75% and you’d end up with money in your client’s pocket.”

In other words, people might think they’re getting a 5% return on their investments, when in fact, after tax, they’re not. Other investments that might not have as high a return attached to them could end up saving the client money.

Another problem with RRSPs is timing. When do you collapse the account? In last year’s federal budget, the government allowed people to keep putting money into their RRSPs until they reach 71, which is good for saving, but not great for withdrawing, as retirees will have less time to pull out more cash.

Rowell says clients should consider taking out money earlier rather than later. “If we start withdrawing at age 60 and control when we take it, maybe we can control tax rates too. Maybe we can get the tax rate down to 30%. We’re changing paradigms, so it’s not just constant defer, defer, but rather control.”

If Rowell had his way, the government would allow people to convert their RRSPs to RIFFs the day they retire. “If a person retires at 55, why can’t they convert and qualify for pension splitting rather than waiting till 65? If the intent of the RRSP is to help fund retirement, why can’t you utilize all the benefits of that when you retire, regardless of what the age is?”

Clearly, there are ways to help ease a client’s RRSP-related tax burden, but it’s up to the advisor to put these tax strategies into practice. Unfortunately, Rowell says many financial professionals aren’t tax-savvy.

He gives the example of a 90-year-old client who converted his RRSP to a RIFF when he was in his sixties. Now, the RIFF is expiring, but the client is still going strong. His advisor told him he had to pull out all his money this year, but Rowell says that’s wrong.

“So what have we done? We switched his advisor, we put his money into another fund and we wrote a new annuity contract. It expired because he took a 20-year RIFF, but in the meantime it continued to grow and earn income, and the advisor was putting it all on his tax return.

“It’s a lack of knowledge on the advisor’s part,” he adds.

But what if an advisor isn’t a tax guru? “It comes down to an inter-advisory team,” Rowell explains. “The financial planner has to utilize the expertise of other advisors.”

So, in the end, investing isn’t always about beating the benchmark —finding the best tax strategy for your clients can put more money in their pocketbook, too.