Tuesday, April 28, 2015

New TFSA Contribution Limits and Reducing Size of RRSP/RRIF

In the Investment section of the Globe and Mail dated Saturday April 25, 2015, there was an article titled "Retirees Can Save Tax by Trimming RRIFs".  This was a theory that I explored back in 2011 prior to retiring, and which I wrote about in my book "Retired At 48 - One Couple's Journey to a Pensionless Retirement". 
At that time, I had created two spreadsheet models to compare the implications to the value of our portfolio and our tax burden between funding our annual retirement expenses by spending all of our non-registered funds first followed by RRSP/RRIF money versus a more balanced approach that drew some funds from all accounts at the same time.  My calculations showed that the balanced withdrawal approach would reduce all accounts at a slower rate, resulting in the total portfolio lasting longer before the money ran out.  By taking smaller amounts from multiple accounts rather than a larger sum from a single account, it allowed each account to maintain a larger balance from which to generate growth and pay dividends or otherwise generate income.  I describe this in more detail in my book.
In addition, by slowly reducing the size of our RRSPs (converted to RRIFs) starting at an earlier age, we would be able to spread out the tax burden of these withdrawals rather than being forced to withdraw huge amounts starting at age 71, due to government enforced minimums. I created a comparison of the total amount of tax paid by age 94 when withdrawing the minimum value starting at age 49 versus age 71.  In both cases, I assumed a starting balance of $300,000 and an investment rate of return of 4%.  Converting to a RRIF at the earlier age results in keeping the value of the RRIF from growing too much, which means the minimum withdrawals also remain relatively low.  Waiting until the mandatory age 71 to convert to a RRIF allows the RRSP to grow significantly in value in the intervening years.  By age 71, the minimum withdrawal percentage is also much larger, resulting in a much larger tax hit, due to our progressive tax rates which tax higher income brackets more than lower ones.  The projected cumulative tax paid on income generated from the RRIF up to age 94 is less for the scenario where the RRSP size is kept smaller (in this example, $107K vs $153K).  The difference would have been even more extreme prior to the recent lowering of RRIF withdrawal percentages at age 71 from 7.38% to 5.28%.

One final advantage of reducing the amount of taxable RRIF income generated in the later years is the impact that income would have on the Old Age Security Pension (OAS), which starts to claw back this benefit for income over a given threshold ($71,592 in 2014).

Part of our RRIF withdrawal strategy was to use money from our RRIF withdrawals to fund our TFSA contributions, thus absorbing the tax hit slowly up front in order to have more tax-free money later on.

At the time when I came up with this concept for early RRIF withdrawal, I was not aware of anyone in the financial industry who was advocating this theory.  Instead, the typical advice from the experts was to hang on to your RRSP money and let it grow tax-free for as long as possible.  To vet my hypothesis, I submitted a question to the financial magazine MoneySense, who contacted a financial planner, Daryl Diamond, president of Winnipeg-based Diamond Retirement Planning, to validate it.  He ran the numbers and confirmed my suspicions, resulting in a MoneySense article published in October 2011.  This same financial planner is referenced in the Globe and Mail article, discussing much of what I originally surmised, but now in context of the recently increased TFSA limit of $10,000.  Lately, I have been seeing more and more analysts write about the same idea that I had years ago.  It is gratifying and reassuring to get further confirmation that I was on the right track back then, despite all the contrary conventional wisdom espoused at the time.

The two new budget items, raising the TFSA contribution limit to $10,000 and reducing the mandatory minimum RRIF withdrawal percentages at age 71, both dovetail into the strategy that my husband and I have already been following since our retirement in 2012.  The only difference is that up to now, we were able to utilize just our dividends in order to fund the RRIF withdrawals and make the TFSA contributions.  Now with the increased limit, we may actually have to sell some stock each year to cover the larger amount.  This actually helps with our goal of slowly decreasing the sizes of our RRIFs, which we accepted intellectually as the right thing to do, but still find emotionally difficult to implement.  Knowing that we are decreasing one savings pool to increase another makes this exercise easier.