Jason Heath: When should you start CPP? What’s the best RRIF strategy? Here’s how to choose the option that best suits you
Some retirees exit the workforce with defined-benefit pensions that replace the bulk of their salary, as well as other retiree perks, such as insurance coverage. For those lucky few, some big retirement question marks are already taken care of, but most retirees are not in this position. How they deal with investment, pension, insurance, and other decisions in the year that they retire can shape the financial picture they face after they stop working. Even for those with DB pensions, these questions can have significant financial implications. Here are four key decisions and how to choose the option that best suits you.
Converting an RRSP to a RRIF
Savers contribute to registered retirement savings plans (RRSPs) during their working years. Ideally, they deduct the contributions from their income when it is highly taxed and take withdrawals in retirement at a lower tax rate.
An account holder can take a withdrawal from an RRSP at any time, including while they are still working, but more often in retirement. RRSP withdrawals are fully taxable and subject to withholding tax by the financial institution where they are held. The tax ranges from 10 to 30 per cent depending on the size of the withdrawal but does not represent the final tax payable. When you file your tax return, the actual tax gets calculated and could be lower or higher than the initial tax withholding.
A retiree can take a single RRSP withdrawal or sporadic RRSP withdrawals as needed over the course of the year. Retirees often convert their RRSP to a registered retirement income fund (RRIF) when they begin withdrawals, and by no later than Dec. 31 of the year that they turn 71.
When an RRSP is converted to a RRIF, the investments remain tax deferred. Contributions can no longer be made to the account and withdrawals are required beginning in the year following conversion. RRIFs have minimum required withdrawals based on a formula that applies a percentage to the account value at the end of the previous year. As an example, someone who is 65 at the start of the year who had a $100,000 RRIF account balance on Dec. 31 of the previous year will have a 4 per cent or $4,000 minimum payout. This minimum increases over time to 5 per cent at 70, 6.82 per cent at 80, and 11.92 per cent by age 90. The result is that the withdrawals generally exceed the account’s income and growth, causing it to shrink over time.
Converting an RRSP to a RRIF at retirement has advantages. Regular monthly withdrawals can be established whereas RRSP withdrawals are a transactional process. Minimum RRIF withdrawals have no tax withheld at source. This does not mean they are not taxable, as the tax will get calculated when the account holder files their tax return. RRIF withdrawals qualify for pension income splitting, so that up to 50 per cent of RRIF income can be transferred to a lower income spouse starting at age 65 on a couple’s tax returns. RRIF withdrawals also qualify for a federal pension income amount saving up to $300 in federal tax and between $59 and $149 provincially in 2022.
Canada Pension Plan (CPP) and Old Age Security (OAS) are the primary government pensions that seniors receive in Canada. CPP is based on historic contributions from employment or self-employment income and OAS is based on years of residency in Canada.
CPP can begin as early as age 60 or be deferred as late as age 70. OAS can start between age 65 and 70. The longer you defer these pensions, the more you are entitled to receive. The later someone expects to live into their 80s or beyond, the more appealing deferring the start of these pensions becomes. A pensioner may receive less income early in retirement but will catch up over time.
CPP increases by more than OAS for each year of deferral after 65 — by 8.4 per cent per year compared to 7.2 per cent. So, if someone wanted to hedge their bets, they could begin OAS and defer CPP.
OAS is a means-tested pension, such that recipients whose income exceeds $81,761 for 2022 may see a reduction in their pension. The repayment amount is 15 per cent of the income exceeding the $81,761 threshold based on net income on line 23400 on a pensioner’s tax return.
You can apply for CPP and OAS online by registering or using an existing My Service Canada Account. You can also submit a paper application to Service Canada, but the processing time may be longer. Low-income seniors may be automatically enrolled to begin OAS and receive a letter shortly after their 64th birthday based on their tax return from the previous year.
Ideally, as an investor approaches retirement, they can fine-tune their investment strategy accordingly. That may not be possible, however, if retirement is unexpected or involuntary. Strategy shifts can be subtle. A saver does not need to go from an all-equity portfolio to cash and bonds simply because they are about to draw down their investments. In fact, some retirees may maintain a similar stock and bond mix as they transition to retirement.
A key consideration in retirement is the time horizon for investment principal. If a retiree can live comfortably off their investment income — like dividends and interest — they may not need to materially change their strategy. However, most retirees will need to dip into their capital and withdraw more than just their investment income.
If an investor has an RRSP/RRIF, a tax-free savings account (TFSA) and a non-registered account, it may be that withdrawals are being taken from the RRSP/RRIF and non-registered investments, but the TFSA can be left to grow.
If one account is being drawn down more on a percentage basis with more principal withdrawals, an investor can consider reducing the stock allocation in that account more than another account.
An investor with an aggressive asset allocation as they enter retirement faces the risk that their sequence of returns is poor with bad stock market returns or multiple years of losses early. An investor with a conservative asset allocation risks missing out on good returns, or that their investments may not keep up with the long-term impact of inflation. Retirement planning can help identify an investor’s required return or sustainable spending based on their specific circumstances.
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Many retirees consider insurance for medical and dental costs in retirement especially if they had employer health coverage. A plan may provide some reimbursement of expenses in exchange for monthly or annual premiums. A list of services or expenses will be covered, subject to initial deductibles or co-payments of each expense and up to annual limits.
If you think about how an insurance policy works, imagine the policy holders pay premiums that total $1 million dollars. If the insurer reimburses $900,000, this insures a profit for them. However, if they reimburse $1.1 million to plan members, the insurer loses money.
Premiums are generally subject to change every year and the average plan member must pay more in premiums than they receive in reimbursements for the insurer to turn a profit. As a result, a private health insurance plan may cost more than it pays out in reimbursements for the average plan member during retirement.
If someone can participate in a retiree plan, they may benefit from competitive premiums that may be partially funded by their former employer. Retirees should consider whether self-insuring and paying their medical expenses out of pocket is better in the long run, especially given a cavity is unlikely to make or break a retiree’s budget. Long-term care costs are the bigger financial risk for a retiree and are generally not covered by a medical and dental plan, though retirees can purchase long-term-care insurance.
Retirees have lots to consider financially beyond these things and must also navigate the social and emotional implications of retiring. The earlier you start, whether on your own or with help, the better prepared you can be for your golden years.
Source: Financial Post