The Great Transition – A Tax Efficient Withdrawal Strategy

Consider a typical married couple, each with pensions, CPP, OAS, RRSPs, non-registered accounts and TFSAs. There could be 12 possible sources of retirement cashflow to tap into. For many, there are even more if, for example, an investment holding company or rental property is thrown into the mix. The biggest expense you will face over the course of retirement is income tax. To help mitigate the total tax you pay, a tax-efficient withdrawal strategy will not only generate the cashflow you need, but also maximize the after-tax wealth that gets passed on to your heirs. Tax bracket management becomes a key part of any withdrawal strategy as it will help minimize and smooth out taxes paid over the entire retirement time horizon and upon death.

Some believe that drawing down RRSPs first is the best strategy. Others believe drawing down non-registered assets first makes more sense. Both can be right depending on the client’s situation. Most often, the best way to create retirement income and draw on your accounts is a mix of both, and this mix may change at different stages of retirement. Every client’s situation is unique, but there are three steps to consider in order to develop a tax-efficient withdrawal strategy.

The first step is to put your retirement assets in buckets.

There are three buckets: taxable, tax-deferred and tax-free. Each bucket is filled up with different types of accounts.

Here is an example of a typical retiree’s investment accounts allocated in the buckets.

The second step is to understand the tax implications of withdrawals from each of the items in the buckets.

• RRSPs and other tax-deferred accounts are taxed at 100% of your marginal tax rate in the year that withdrawals are made.
• A non-registered account will be taxed based on how the account is invested and what type of income is generated each year. Typically, this is a combination of cash, bonds and stocks. Interest income generated each year is fully taxed at your marginal tax rate, whereas 50% of each year’s realized capital gains are taxed at your marginal tax rate. The effective tax rate on Canadian dividends is more complicated, but these are also taxed at a preferred rate which is effectively less than your marginal tax rate.
• Then you have TFSA withdrawals which have no tax at all.

The third step is to have an idea of what your (and your spouse’s, if applicable) marginal tax rate will look like each year throughout your retirement.

Your actual marginal tax rate from year to year is a significant determinant in considering which of your retirement savings to draw on and when.

The trick to withdrawing your savings in the most tax efficient way is to take money from the buckets with the highest tax liability at the lowest possible marginal tax rate, then top it off with money from buckets with little or no tax. When you are in a lower tax bracket, you should consider withdrawing from tax-deferred accounts, and when you are in a higher tax bracket you should consider withdrawing from non-registered accounts. As your TFSA can continue to grow tax free, it should be kept for emergencies or for your estate.

Putting together a retirement withdrawal strategy without considering all the above steps could result in higher taxes over your lifetime and in your estate or, even worse, it could impact the longevity of your hard-earned savings.