Converting from an RRSP to a TFSA before retirement

Website design By BotEap.comThere are solutions to this question which are converting to a Registered Retirement Income Fund (RRIF), purchasing an annuity, or perhaps withdrawing the money earlier and for a longer period of time. The TFSA creates another strategy that can be useful for certain situations.

Website design By BotEap.comWhat’s wrong with current strategies?

Website design By BotEap.comThe answer is nothing, but the limitations may not be suitable for some people. In the case of an RRIF, once you turn 71, you are now prescribed how much you withdraw and there are few options. Once you reach age 94, you will need to withdraw 20% of your RRIF with the intention of withdrawing all funds in a short time. You can withdraw more than the prescribed amount, but you will be penalized with taxes. If you buy an annuity, you are subject to the rules of the annuity contract. Like any complicated contract, you’ll need guidance on the best terms and there’s no guarantee that your interests will be looked after in retirement. Other solutions can be more complicated, which usually means more cost and expertise to implement.

Website design By BotEap.comWhat is the new strategy?

Website design By BotEap.comUnder current RRSP rules, you contribute money and get a tax refund at the time you contribute. However, you will pay taxes later at the time of withdrawal. The TFSA is the other way around. You don’t get the tax benefit upfront, but you won’t pay tax later when you withdraw. The strategy is to slowly withdraw money from your RRSP, pay taxes when you do, and then protect that money in a TFSA. The theory is that if you do this at age 50 or 60, you probably have another 20 or 30 years to invest this money. If you can pay taxes up front and then let the money grow within the TFSA, you can have a tax-free investment portfolio with no surprises later. If the power of compounding can work to grow your money in an RRSP, it can do the same in the TFSA. More money generated from investments would mean that more taxes are generally paid. However, in the case of the TFSA, this would not be the case.

Website design By BotEap.comThere is no tax bill at the end of the compounding period. The catch is that you pay the taxes on the original withdrawal from the RRSP, but that would be more than made up within the TFSA at a later time. This is assuming that the current tax rules remain as they are. If they change and TFSA withdrawals are limited or taxed in some way, this strategy would not be helpful. The rules for any registered account can change at any time, so this risk exists for RRIF, RRSP or any other registered account.

Website design By BotEap.comHow do you actually implement this idea?

Website design By BotEap.comEvery year, you can withdraw money from the RRSP. You will pay taxes on the withdrawal. He then takes this money and deposits it into the TFSA account and invests in the same way. As an example, if someone is 55 years old, she is paid $50,000 per year at her job and has $300,000 accumulated in her RRSPs. They have about 15 years before the money they have turns into a RRIF. Since the TFSA limit is only $25,500 per person and is increasing by about $5,000 per year, we will use these as the maximum amounts that can be transferred. In this example, it is assumed that the $25,500 has already been used up, so only future transfers will be considered. If this person leaves the money in the RRSP and then transfers it to an RRIF, she will be forced to withdraw about 7% of the money each year at retirement. This percentage will increase each year, but we will use it as a conservative estimate. It will also be assumed that the lower tax bracket will be used at retirement, which probably means they are receiving income from CPP, OAS, RRIF, and maybe a small pension payment, but not much else. Your income would be less than $35,000 per year combined. This means that their tax bracket is around 30% when they are working and 20% when they retire. Your ROI over the life of the RRSP and TFSA will be assumed to be 5%.

Website design By BotEap.comKeep in mind that 7% of the RRSP account withdrawn would add up to $21,000 in income per year. Since the TFSA limit is currently $5,000 per year, we will use $5,000 per year as the transfer amount. The remainder of this RRIF withdrawal would add considerable income to the retiree, as an RRSP of $300,000 would be close to $600,000 at age 71. The 7% withdrawal rate on this amount would mean an additional $42,000 in additional income, resulting in a higher tax bracket. Total income after age 71 is assumed to exceed $70,000 with an assumed tax rate of 40%.

Website design By BotEap.comIf this person leaves the money in the RRSP, and then withdraws the money as an RRIF, they will be taxed at 40% each and every year the RRIF has. For $5000 per year at 40%, they will pay $2000 per year in taxes until death. If this person lives to age 85, which is around the average life expectancy, he will be paying $30,000 in taxes. If they withdraw $5,000 from their RRSP before retirement, starting at age 55, they will pay about $1,500 in taxes each year they do this, and then $2,000 per year after age 71. This would add up to $1,500 x 16 years plus $2,000 x 15 years or $54,000 in taxes. However, the money in the TFSA is now tax free for the rest of your life. If they invest this money in the TFSA at $5,000 per year and earn 5% each year for 30 years (85 years minus 55 years), they will earn over $147,000 in extra money. The taxes saved on this additional money would exceed $52,000, which would nearly negate the additional taxes paid in advance on RRSP withdrawals. This would be a net savings of about $28,000 in taxes over their lifetime, assuming they live at least 85 years. The return on reinvestment of taxes paid in advance is also factored into this calculation.

Website design By BotEap.comWhat are the advantages?

Website design By BotEap.comIf you have multiple sources of income, this strategy may allow you to tax shield some of your income in retirement, thereby lowering your income thresholds. If you are receiving Old Age Insurance, this may allow you to increase what you are receiving. If you are receiving a private pension or RRIF payments, this strategy can reduce your overall tax bill by reducing your total income in any given year. The details of this timing will need to be discussed with your tax professional, as it will differ with each person and for each year in some cases.

Website design By BotEap.comWho can benefit from the strategy?

Website design By BotEap.comIf you receive CPP and OAS only in retirement and a very large RRSP that would translate into a large RRIF income in retirement, this idea may be enough to reduce your income and increase your OAS payments. If your income declines at retirement, or you retire early, this strategy can be used in the years between your retirement age and age 65 or age 71, depending on which accounts you have.

Website design By BotEap.comWhat are the limitations?

Website design By BotEap.comCurrently, you can only contribute $25,500 per person to a TFSA. However, if the government continues to increase the limit each year, it will increase by at least $5,000 per year, which in 10 years would make an additional $50,000 available. If you have a spouse, these amounts can be doubled. This is potentially $150,000 that may be subject to this strategy which will have a tax impact. If inflation rises, these numbers may be higher as the government seems interested in keeping these limits in line with inflation. The additional $500 added for 2012 is consistent with this argument. You can also continue with this methodology until retirement. If you don’t need the income, you can defer it indefinitely until you need it, and reduce your taxes gradually each year, as future investment income will be increasingly shielded from tax.

Website design By BotEap.comThe money in your RRSP is supposed to be for retirement, which means it’s money you don’t need except for retirement purposes. If you withdraw from your RRSP, roll over to a TFSA, and then spend it because it’s easy to do, this strategy won’t be of benefit. You can also use the TFSA as an emergency account, which is nice, but you will have to choose what your intention is to get the most benefit from what you want to achieve. Leaving money in the TFSA account for a long period of time will exceed the taxes you must pay in advance and prevent future taxes. Conventional wisdom says you should defer taxes as long as possible, but you’ll always have to pay taxes somewhere, so the ideal scenario would be to weigh your options and optimize what’s best for you based on your lifestyle, income and preferences. If the wisdom of paying taxes later is always true, there would be no problem paying large taxes on RRSP withdrawals, or taxes on wealth in transition to the next generation.

Website design By BotEap.comFrom an investment standpoint, a TFSA can have most of the same investments as an RRSP, so nothing is lost from an investment standpoint. What was sold on the RRSP can be bought back on the TFSA. The difference here is strictly due to the timing of tax payment.

Website design By BotEap.comThe TFSA can be used in conjunction with the RRSP and RRIF to save taxes if implemented in the right situation and at the right time. As you can see in this article, there are many assumptions to examine and the best way to do this calculation would be to run several scenarios to see which one best suits you. Even if you do this, things can change, so the calculation should be revisited any time an assumption changes: tax rates, investment returns, earned income, or RRSP amounts, to name a few.