Upon retirement, you will be converting your working years’ accumulated savings into income in order to fund your financial goals.
In transitioning to your next chapter, it is important to have a Total Wealth Plan that considers a wide range of issues, including lifestyle expenses, longevity, interest rates, inflation rates, tax rates, market volatility and legacy planning. Of course, some of these items are beyond your control; however, you can still manage your expenses, determine your retirement age, and dictate the taxes you need to pay. Taxation, in particular, is an important aspect of retirement income planning, as some sources of income are taxed more favourably than others. Understanding these differences and planning around them can significantly impact the cash flow available to meet your goals and what you leave behind in your estate.
This article will explore the different sources of retirement income and how they are taxed.
Sources of retirement income
Common sources of retirement income include pensions, government benefits, registered plans, and non-registered investments. One often-asked question is which source of income to draw from first and how much to draw. Unfortunately, there is no one-size-fits-all strategy; everyone has different needs. Therefore, it is critical to understand the need for cash flow and how it will be accomplished based on your specific situation. Understanding your unique needs will assist you in determining how much money is enough for your retirement years. One common strategy is to layer different guaranteed and non-guaranteed income sources to draw tax-efficient funds sufficient for retirement spending.
Public pensions and government benefits
In Canada, the government provides retirement benefits based on an individual’s income and contributions during their working years. The three main government benefits that retirees can apply for include the Canada Pension Plan (CPP)/ Quebec Pension Plan (QPP), Old Age Security (OAS), and a Guaranteed Income Supplement (GIS).
CPP monthly payments are taxable, and distribution can begin at age 65. The payment amounts depend on the premiums contributed to the plan and the age the pensioner begins to receive such payments. Enhancements were made to the CPP in 2019 to increase the amount to current pensioners. The benefits will increase from 25% to 33% of pensionable earnings, which will increase the premium payments from 2019 to 2023.
OAS monthly payments are also taxable and payable to Canadians aged 65 or older. Unlike CPP, OAS payments do not require contributions to the plan; however, they do consider the number of years of residency in Canada. The amount may be reduced if an individual spends less than 40 years in Canada after the age of 18. Furthermore, the benefit amount may be clawed back if the annual income exceeds the OAS threshold. The individual will be required to repay the government the pension income at 15% of the net income above the threshold.
OAS recipients may also qualify for GIS if their annual income is lower than the yearly maximum exemption amount. GIS will be eliminated if the taxpayer’s annual earnings exceed $3,500. The exemption amount is based on marital status and the current year’s income. The monthly payment is not taxable.
The government also provides allowances to low-income retirees aged 60 to 65 if their spouse is eligible for the GIS (allowance for people aged 60 to 64) or if their spouse has passed away (allowance for the survivor). Both allowances are not taxable.
Moreover, if the CPP and OAS recipient passes, the CPP Survivor’s benefit and OAS allowance for the survivor will be payable to the surviving spouse or common-law partner of the deceased. The CPP Survivor’s benefit is based on a few factors, including the age of the surviving spouse, other pension or disability benefits, and the deceased’s contribution to the CPP. The OAS allowance for the survivor is based on annual income. It is essential to notify the government upon the death of the benefit’s recipient to apply for the survivor’s benefit.
Please refer to our Retirement planning figures for the 2021 maximum government benefit amounts and their thresholds, if any.
When should one apply to receive CPP and OAS?
Canadians have some flexibility around when they elect to receive CPP and OAS. CPP benefits can be received as early as age 60. However, the payment will be reduced by 0.6% each month before age 65 when they receive this early pension. Therefore, the maximum pension reduction would be 36% if you decided to begin the CPP payment at age 60.
On the other hand, there is a 0.7% increase for each month you choose to defer your CPP payment beyond age 65, up to a maximum 42% increase at age 70. Similarly, OAS offers a payment deferral option for up to 5 years. If payments are deferred, there will be an increase of 0.6% for each month the payment is postponed, to a maximum of 36% increase at age 70. There is no option to receive OAS before age 65.
A key benefit of receiving payments later is larger monthly payments. Another advantage of deferring payments would be managing tax brackets, especially if the pensioner receives OAS payments. As mentioned above, OAS would be clawed back when annual income exceeds the threshold; hence, deferring income from CPP or OAS benefits may reduce the clawback. Furthermore, GIS and other government allowances may be reduced if the total income exceeds the allowances’ respective thresholds. Therefore, keeping the net income below the thresholds may maximize the benefit payments.
Although there are benefits to deferring the payments, it is not necessarily the best option for everyone. Unfortunately, there isn’t a rule of thumb for the optimal age to start the benefit, as it depends on personal factors. First, if you require cash to fund your current expenses, you may not be able to wait a few more years to withdraw. Second, life expectancy may also affect the decision of whether to defer the payments. This is a difficult factor to consider as it is nearly impossible to predict one’s lifespan. However, unhealthy individuals who do not expect to live long may wish to receive the payment sooner.
Private pensions
Private pensions are generally employer-sponsored, often referred to as Registered Pension Plans (RPPs), but there are also Individual Pension Plans (IPPs) for private corporation business owner-managers. RPPs can be defined benefit (DB) or defined contribution (DC) plans, and participants receive periodic monthly pension payments upon retirement. DC plan payouts are based on the plan’s contributions and accumulated investment funds. Payments from DB plans are pre-determined based on the number of service years, salary, and additional contributions, if any.
The payments from all private pensions are taxable.
Registered plans
Those who do not have an employer-sponsored plan can accumulate retirement savings in private registered plans, such as a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
There is no obligation to withdraw from an RRSP under age 71, and you can control the timing and the amount you wish to withdraw. On December 31 of the year you turn 71, you must convert your RRSP to a Registered Retirement Income Fund (RRIF) and begin withdrawing at least the age minimum withdrawal limits. Any withdrawals above that amount will be subject to withholding taxes. Alternatively, the RSP can be collapsed and the entire balance taken into income, or the accumulated funds can be used to purchase a life annuity, which would provide annual income every year for life. All RRSP or RRIF (or registered annuity) withdrawals are fully taxable.
A TFSA is also a great saving tool. Unlike the RRSP, the growth and withdrawals are entirely tax-free. This is an important attribute, especially considering the impact on OAS clawback and income-tested government allowances. As mentioned, structuring income from different sources depends on the individual’s circumstances.
| Sources of income | Tax treatment |
|---|---|
| Interest income (From debt securities such as bonds, GICs, money market and bond funds) | 100% at the marginal tax rate (MTR) |
| Dividends from a publicly-traded Canadian corporation | Eligible dividend income is grossed up by 38% and eligible for Federal and Provincial dividend tax credits |
| Foreign dividends | 100% at the MTR |
| Capital gains (when sale proceeds exceed the costs) | 50% of the realized capital gains are taxable at the MTR |
| Return on capital from investments | Not taxable; however, the payout amount reduces the investment’s adjusted cost base, which will increase the future capital gains upon disposition |
Other funding
Private corporations
Business owners of private corporations may have the flexibility to draw different funds out from their corporations during their retirement. The most common approach is to take taxable, non-eligible dividends, which provide a small dividend tax credit. Corporations may also distribute tax-free dividends from their Capital Dividend Account (if there is a balance) or repay any remaining shareholder loans, which would also be tax-free.
The owner-managers of the corporations may also receive pension payments from an IPP if they set one up. They can start receiving the pension as early as 50 years old or defer as late as 71.
The shareholders can also sell their business to extract more cash. Any capital gains resulting from the sale are taxable. However, some shareholders may be eligible to claim a Lifetime Capital Gains Exemption (LCGE) (up to $892,218 in 2021) to offset this gain if certain conditions are met. The discussion on LCGE is beyond the scope of this article.
Other options
If more funds are still required for retirement, one may look at using a credit facility to supplement income. For anyone with accumulated cash values inside a permanent life insurance policy, they can be used as collateral for tax-free loans. For individuals with several years to retirement and excess capital or cash flow, redirecting assets into a permanent life insurance policy can yield significant benefits, including tax-free growth and the flexibility to generate this supplemental retirement income.
Many retirees sell their family home and move to smaller, less expensive homes. Downsizing their home could decrease any outstanding mortgage payments or maintenance costs, which generally means more cash in their pocket to spend.
These extra funding options could also be used for future planning, such as estate, gifting, or luxury expenses.
Summary
Retirement income planning should consider all available income sources and related tax implications to provide a better picture of after-tax cash flow in retirement to maximize retirement while protecting your estate. For example, if the individual’s income level is almost at the OAS allowance threshold, but they still require more cash, they may wish to draw from their TFSA to fulfill the additional needs and not trigger any taxable income that would reduce their benefit amount. This, however, may not be an option if the individual is 71 years old and required to withdraw from their RRIF. As such, it is advisable to call our office to learn more about Total Wealth Planning and how it can help you achieve your goals.
Speak with your own tax advisors about your own tax situation before implementing any tax planning strategies.
source https://rosenbergdri.ca/retirement-tax-planning-tips-sources-of-retirement-income/
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