It is important to remember that with each passing year, we come closer to retirement. We tend to focus on the current commitments like making our regular mortgage payments and put off future planning until tomorrow…and then tomorrow never comes.
The maximum Canada Pension and Old Age Security benefits you can receive in retirement are typically less than $20,000 annually. Remember, that figure is based on taxpayers who earned enough during their working years in order to maximize their CPP contributions each year. Many Canadian taxpayers are not in that position and therefore will receive less benefits.
So what are our options in saving for retirement? In Canada, we presently have two savings alternatives that allow you to earn income on a tax-free basis and accumulate a nest egg to live on down the road. Both have different rules and are good choices for different circumstances.
Our two options are: the age-old Registered Retirement Savings Plan (RRSP) or the recently created (2009) Tax Free Savings Account (TFSA).
RRSP contributions are tax deductible (reduces your taxable income) in the year that they are made. Your investment then attracts income inside the RRSP and when you make a withdrawal, both the original investment and any earnings withdrawn are taxable in that year. The amount you can contribute to your RRSP depends upon the amount of income earned on qualifying income such as employment earnings. Unused contribution room from previous years carry forward. If you make a withdrawal, your contribution room does not refresh itself - it is permanently gone.
Investing in RRSPs is a good option if you have a higher level of income in any tax year. The contribution will help to offset some of the current year’s tax obligation. This approach can be advantageous if you anticipate being in a lower tax bracket in the year you intend on withdrawing the funds. For example: save tax at a high rate in contribution year, pay tax on the income at a lower tax rate all the while earning investment income compounding on a tax-free basis during the years in between.
The TFSA account allows you to make annual contributions of up to $10,000 based on the 2015 Economic Action plan released on April 24, 2015 (which is pending parliamentary approval.) If you’ve not yet contributed to a TFSA, your total accumulated room is $41,000 based on the past contribution limits and the proposed increase. Remember, this is the total amount of principal you are permitted to invest. As you earn returns on this investment, the balance in your account will continue to grow. The benefits with a TFSA are that you can withdraw your funds at any time without any tax implications and your contribution room replenishes itself on January 1st of the year following the withdrawal. Again, investment income is earned tax-free just like the RRSP. This vehicle can be useful if you are in a lower tax bracket and thus the tax savings of an RRSP contribution may not be worthwhile given the lack of flexibility on withdrawals and contributions without tax consequences and erosion of contribution room. For some people, the TFSA’s flexibility may pose a disadvantage in that the funds are more accessible and therefore can be withdrawn on a whim.
If you will have significant income in your retirement years from sources such as a workplace pension plan or unregistered investments, RRSP balances and withdrawals should be carefully considered. You have to convert an RRSP to a Registered Retirement Income Fund (RRIF) by the end of the year in which you turn 71. The year following, you are required to make minimum annual withdrawals and the percentage of your RRIF you must withdraw increases each year.
This is where it is very important to plan properly. In some cases, it may make some sense to withdraw some of your RRSP monies prior to when the minimum withdrawal amounts come into force. This approach will better enable you to manage the amount of taxable income you might have and avoid being taxed in higher tax brackets or have some or all of your OAS benefits clawed back. After all, you’ve worked hard for your money, so let’s try to ensure you don’t give any more of it than necessary to the government.
We work with several clients to effectively plan out a strategy based on their specific needs, income levels, lifestyle expectations and many other factors. Given all of the considerations, it is worth your while to talk to a qualified professional to gain an understanding of what approach may be the best option for you.
Plan now. Don’t put it off. The sooner you can get a strategy in place (and balance planning for the future with present day commitments) the sooner you can reap the benefits of your hard work.