In the past, most Canadians relied heavily on employer pension plans and government pension plans to provide a source of income in retirement. These days, many employers no longer offer pension plans, and individuals frequently change careers and employers. As such, the Registered Retirement Savings Plan, or RRSP, has become one of the most common retirement savings plans in Canada. In fact, a recent study indicates that 69 percent of Canadians now have an RRSP account, up from 60 percent just last year.
Yet, while many Canadians have a plan for making RRSP contributions, very few have a plan for RRSP withdrawals. How do you plan to take the money out of your RRSP?
Although there are many intricate details of RRSPs, the basic functionality of an RRSP is straightforward:
- You earn an income-tax deduction when you contribute to your RRSP
- Your money grows tax-sheltered while it is inside your RRSP
- You pay tax on any amounts you withdraw from your RRSP
One of the rules of RRSPs is that, eventually, the account must be closed. The rule states that your RRSP must “mature,” or must be “wound up,” no later than December 31st of the year in which you turn age 71. Note the key date here is not your 71st birthday, but rather, December 31st of that year.
Further, note that the rule indicates “no later than,” so any of the options described below are also available before that date as well. That is, you don’t have to wait until the year you turn age 71, and you can wind up your RRSP any time before that as well. However, after December 31st of the year in which you turn age 71, you can no longer own an RRSP account – All funds must be moved out of your RRSP and the account must be closed.
When it comes time to wind up your RRSP, you basically have 3 options available:
1. Open a Registered Retirement Income Fund (RRIF) and transfer the funds from your RRSP to your RRIF. This is by far the most common option for retirees. The transfer itself is tax-deferred, so no taxes are owing when the funds are transferred from RRSP to RRIF. Further, you can still maintain full control of your investments, and still keep the same investments if you wish – the list of eligible investments is the same for RRSPs and RRIFs.
The key difference between the accounts is that, unlike your RRSP, your RRIF will have mandatory minimum withdrawals. There is no maximum withdrawal limit, but there is a mandatory minimum – you have to withdraw a certain minimum amount from your RRIF each year, whether you want to or not. The mandatory minimum amount you have to withdraw year is based on your age and the amount of money in your RRIF. Although RRIF withdrawals are taxable as regular income, no tax is withheld on the minimum RRIF payments. A good practice is therefore to set aside a portion of your RRIF payments to cover any additional taxes owing at tax time.
2. Purchase an annuity with the funds in your RRSP. This is the second most common option for retirees. An annuity is a financial product where, in exchange for a lump sum, you receive a series of payments over time. In this sense, buying an annuity can be thought of as buying your own personal pension – the product provides you with a regular income stream, regardless of market ups and downs. When an annuity is purchased with funds from your RRSP, it is considered a “registered annuity,” and as such, each annuity payment is fully taxable as income. Similar to the RRIF strategy, it’s a good idea to save a portion of your annuity payments in case you have any additional amounts owing when you file your income taxes for the year.
Although annuities can be a great tool to provide a stable and secure retirement income, many retirees are still reluctant to use them. This often stems from a psychological barrier, as many investors are hesitant to hand over their money and relinquish control of their capital. Nonetheless, annuities can prove a great product for retirees, and can help insulate you against many risks that would otherwise threaten your retirement income. For more information about annuities in general, and some key considerations to help you decide if this is the best option for you, check out our previous ModernAdvisor post on annuities.
3. Withdraw all of the funds from your RRSP. Of the different options available, this is the least popular of all. Although this option is perhaps the most straightforward and easiest to understand, it also has the least favourable tax treatment.
Recall that there is no maximum limit on the amount you can withdraw from your RRSP. As such, you can just withdraw it all, and then close the RRSP. However, in doing so, the entire amount would be added to your income for that year and taxed at your marginal rate. That could be a very high rate, and could result in a very large tax bill, especially for RRSP accounts with a large balance. For that reason alone, this option is generally not advisable due to the resulting tax consequences.
Keep in mind that this does not have to be an all-or-nothing decision. That is, you can also choose any combination of the 3 options mentioned above. For example, if you had an RRSP with $200,000, you could decide to withdraw $10,000, transfer $90,000 to a RRIF, and purchase an annuity for $100,000.
While there is no “right” or “wrong” answer for deciding how to manage your RRSP at maturity, it’s important to choose the option that’s most suitable for your retirement income needs, and your own personal investment preferences.
If you would like to have a discussion with a Portfolio Manager or Certified Financial Planner, just contact us.