Decumulate & Downsize

Most of your investing life you and your adviser (if you have one) are focused on wealth accumulation. But, we tend to forget, eventually the whole idea of this long process of delayed gratification is to actually spend this money! That’s decumulation as opposed to wealth accumulation. This stage may also involve downsizing from larger homes to smaller ones or condos, moving to the country or otherwise simplifying your life and jettisoning possessions that may tie you down.

Retirement planning software and the 70% Rule

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By Ian Moyer

(Sponsor Content)

Individuals who are following conventional retirement-planning may be in disbelief as they approach retirement and discover that they cannot afford to retire just yet or are likely to outlive their retirement funds.

The 70% Rule

Common practice is to save enough so that your annual retirement income equals about 70% or more of your current income. Of course, many Canadians are not aware of such information entirely and have saved little or not enough for their retirement.

With this being said, there are still some fundamental issues with this understanding. One, few people have a complete understanding of their retirement resources or a realistic view of their retirement funds. In some cases, 70% retirement pay usually isn’t enough to sustain them in retirement.

Example

We’ll use the fictitious name Tom for this example. Tom is making $60,000 annually living a modest lifestyle. Tom will qualify for CPP and OAS. Tom only contributes through his employer-directed contribution program, which is $2500 a year.

Tom also saves $13,000 in a regular checking account, an additional $3,000 in non-registered savings and $12,000. Tom is a conservative investor and he thought he was doing pretty well saving what he can and living a modest lifestyle.

Using Cascades to do retirement planning at the age of 54 using the above figures. Tom discovers his annual income will only be approximately $38,250. After taxes per year. Going back to the common practice of 70% Tom needed minimum $42,000 per year as retirement income. This leaves Tom needing to find a way to make an additional $3750 a year. Tom would need a part-time job, choose not to retire or drastically change his lifestyle in retirement.

For a lot of individuals, they will have to work longer than they planned or seek part-time employment during retirement. This could be a problem for retirees and employers. In order to navigate this issue before it starts employers need to assist their employees with retirement planning.

Sample Cascades recommendations for maximizing an estate

How can we change this?

The first step would be for employers to become more effective at helping employees realistically prepare for and manage their retirement. For example, this could include a process or program to build up wealth accumulation prior to retirement, which could be a mix of LIRA, Capital Gains or RRSP just to name a few.

A second step would be for employees to change their behaviours and thoughts around retirement savings. Employees can make changes by becoming more proactive when it comes to saving. When some individuals think about saving for retirement after they attend school, buy a home, raise children and send them to college sometimes it can be too late. Continue Reading…

Retired Money: How retirees can lower RRIF tax shock by taxing “at source” wherever possible

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My latest MoneySense column takes a look at the supposed “tax nightmare” new retirees sometimes face on the forced annual (and taxable) withdrawals of Registered Retirement Income Funds or RRIFs. Click on the highlighted headline for the full article: How to avoid tax payment nightmares when the RRIF withdrawals start.

It’s a simple idea really. Salaried employees take for granted the automatic deduction of income taxes “at source.” They receive their regular paycheque with “net” or after-tax deposits that go directly into their bank accounts.

RRIFs are famously taxable: once you reach the end of your 71styear, you are required to pay an ever-rising minimum percentage withdrawal, all fully taxed like earned income or interest. However, notes Aaron Hector, a financial planner with Calgary-based Doherty & Bryant Financial Strategists, there is no mandatory withholding tax on RRIFs, unlike the 10, 20% or 30% tax that must be withheld at source on RRSP withdrawals (which rises with amount withdrawn.)

Fortunately, you can ask your financial institution to deduct tax at source every time you make a RRIF withdrawal. Alternatively, new retirees or semi-retirees may wait till 71 to start a RRIF but choose to withdraw money from their RRSP whenever they need it during their 60s. Here, the problem is the minimum withholding required can prove to be inadequate if you take out chunks of RRSP cash that are too small. Take them out in $5,000 chunks or less and the 10% (5% in Quebec) withholding tax is unlikely to be sufficient once you file your annual return.

Try and take out at least an amount between $5,000 and $15,000, which results in a 20% withholding tax (10% in Quebec.). Better yet, make the withdrawals $15,000 or more and pay the 30% withholding tax (15% in Quebec). Don’t fret that this may be “too much” tax: if so, it will be rectified once you file your next tax return. You can find a summary of RRSP withholding rates at this Government of Canada website.

Hector says RRIF withdrawals in excess of the minimum annual required payment are treated the same as regular RRSP withdrawals for withholding tax. So if your minimum RRIF payment one year is $50,000 but you withdraw $100,000, the extra $50,000 will be taxed at 30% on withdrawals and come tax time, you’d pay tax on the entire $100,000. You can elect to have taxes withheld at source on the minimum RRIF payments as well: Hector estimates a third of his clients do just that. Others may end up making quarterly tax installments instead.

This situation is aggravated by the fact non-registered investment income is typically taxable.             Fortunately, you can choose to deliberately overtax yourself as you go on many common sources of retirement income: if you receive pensions from former employers and/or the Government (CPP, OAS), you can set things up to mimic the “taxed at source” setup salaried workers have. While not mandatory, pension administrators will deduct whatever percentage of tax you wish to arrange with them, whether a minimal amount or a near-confiscatory 50%, or somewhere between those extremes.

In my case, I set 30% as my withholding tax on corporate pensions, 25% on OAS and eventually the same amount for CPP. You may feel small pensions don’t have to be taxed at source if they are less than the Basic Personal Amount that is tax free to everyone: $11,809 in 2018, $12,609 in 2019.

The alternative is quarterly tax installments. Retired advisor Warren Baldwin says theCRA sends notices for payments based on simple arithmetic applied to the previous year’s taxes. “So if, for example, 2017 was a high-income year and you had a high tax liability on filing, CRA will request large payments in March and June of 2019. If income and the liability declines in 2018/19, then you might have overpaid and need to wait until spring of 2020 for the refund.”

Ideally, things will balance out when it comes time to file your taxes: if you went overboard in taxing yourself at source, you may end up with a refund; if you underestimated your taxes due, you may end up having to cut yet another cheque to Ottawa. Some object to giving the CRA an “interest-free” loan but personally, I’d rather receive a small refund than have to pay still more at tax time.

OAS clawback secrets for the high-net-worth

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By Aaron Hector, RFP

Special to the Financial Independence Hub

I’m going to start this off by saying that I’ve searched high and low for an article, website, blog – anything – that backs up some of the planning concepts I’m about to share with you on the subject of Old Age Security (OAS). I couldn’t find anything, so it’s with a certain degree of hesitancy that I find myself writing this. Even though I believe the concepts are factually correct, they’re largely unproven in practice.

I’ve come to realize that the majority of writing, thinking, and media coverage surrounding government pensions like OAS and CPP (QPP in Quebec) are targeted towards households in the middle-to-upper-middle-income or net-worth range, and the planning opportunities for high-income and high-net-worth households are often overlooked. With this article, I’m going to try and change that.

I’ll start with a bit of background information.

OAS deferral enhancement: choosing your start date

The introduction, in July 2013, of deferral premiumsfor Old Age Security has given Canadians and their financial planners a lot to think about. What was once a fairly standard ‘take it or leave it’ choice at age 65 has become a more complex decision. The complexity stems from the fact that for each month you delay the payment of your OAS past the age of 65, your lifetime monthly payment will be increased by 0.6%. This enhancement is maxed out at 36% if you postpone it to age 70. Don’t overlook the planning options available to you when choosing your start date. When you do the math, there are sixty potential start dates, and sixty potential payment amounts: one for each month between ages 65 and 70.

Choosing an effective start date: immediate vs. retroactive

Here’s another wrinkle. If you apply for OAS after age 65, you can choose a start date that’s up to one year earlier than the current date on your application. So, if you’re applying in January 2020, you could choose your OAS payments to begin as early as February 2019. All payments will be based on whatever age you were as of February 2019, and you’ll be paid a retroactive lump sum for the period between February 2019 and January 2020 (or whenever your application is approved and processed). Following the lump sum, you’ll get the regular ongoing monthly OAS payments, again, which will be based on your age as of February 2019.

Another important fact is that the retroactive lump sum payment is included on your T4A (OAS) slip in the year that it’s received. So, if you apply for a retroactive start date that reaches back to a prior calendar year, it will still be income for the current year when received. This is important because it lets you shift your initial OAS income from a less desirable tax year to a more desirable tax year. This would be of value if you retired in one year (while in a high marginal tax bracket), and shifted your OAS for the first year into the following year when you’re fully retired and in a lower tax bracket.

Understanding the clawback

It makes sense that most people would dismiss OAS planning for high-income and high-net-worth Canadians. After all, OAS is famously clawed back by 15 cents for each dollar that your net income exceeds a certain annual threshold and is entirely clawed back when it reaches another. The stated clawback range on the Government of Canada’s website for 2019 income is $77,580 to $125,937. I refer to these limits as the clawback floor ($77,580) and the clawback ceiling ($125,937). For a Canadian whose income is expected to always exceed $125,937, one might conclude that there’s nothing that can be done to preserve any OAS. That would be an incorrect conclusion.

OAS secret number 1 – the clawback ceiling is NOT $125,937 for everyone

Let’s review the math of OAS clawback. OAS is eroded at a rate of 15 cents for each dollar your net income exceeds the clawback floor in any given tax year. If you started your OAS at age 65, then in 2019 you would expect to receive OAS payments which total $7,253.50 (assuming OAS is not indexed in the fourth quarter of 2019, which is yet to be confirmed). The clawback ceiling is $125,937 because with a clawback floor of $77,580 and an erosion rate of 15 cents per dollar, your $7,253.50 of OAS is fully eliminated by the time your income reaches $125,937 ($125,937 minus $77,580 = $48,357, and $48,357 x 0.15 = $7,253).

I get frustrated when I see a reference to the OAS clawback ceiling because every article or resource that I’ve seen completely ignores the deferral enhancement. Due to the method with which the OAS Recovery Tax or clawback is calculated, a more robust OAS pension will result in a higher OAS clawback ceiling. So, while the clawback floor is a fixed number which is set each year by the CRA, the clawback ceiling is not a fixed number. Rather, it’s a sliding number based on the amount of OAS that you actually receive. Sure, if you take OAS at age 65 (like most people), your clawback ceiling for 2019 is going to be the stated $125,937. But if you’re receiving higher payments due to postponing your start date, you’ll have a higher clawback ceiling. For example, if you delay your OAS to age 67, you’ll actually have a ceiling of nearly $133,000, and if you delay your OAS to age 70, your clawback ceiling will exceed $143,000.

Source: Aaron Hector, Doherty & Bryant Financial Strategists

This enhanced clawback ceiling provides opportunities for some very interesting planning. Retirees who don’t expect to keep any of their OAS because they forecast that their retirement income will be in the $125,000 range might need to reconsider and potentially wait to start their OAS until 70. For others, it may be best to take OAS at age 65 because when their RRSP is converted to a RRIF, their income will exceed even the $143,000 range. Perhaps an early RRSP melt-down strategy combined with OAS postponement to age 70 will achieve the best result.

Ultimately, the right decision will depend on various individual metrics, such as your projected income in the years between ages 65 and 70, and into the future. The size of your RRSP and eventual RRIF will also be a factor, as well as your health and expected longevity (and that of your spouse, if applicable). There are truly too many factors to determine the best course for the broad population; my point here is simply that the enhanced clawback ceiling should be one factor to consider within the mix.

As an aside, the clawback ceiling is similarly lowered for those who do not qualify for a full OAS pension. This would be the case for those who have not met the full residency requirements. For example, someone who only receives half of the full OAS pension for 2019 ($3,627) will have their OAS fully clawed back when their income reaches $101,758.

OAS secret number 2 – how to create an OAS “super-ceiling”

Now that we’re all experts on OAS clawback, and we acknowledge that the OAS ceiling is not a fixed number but actually a range, we can consider some further niche planning opportunities.

For example, is there any way for someone with an expected retirement income of $150,000 per year to ever take advantage of OAS? This level of income exceeds the $143,000 upper ceiling range for someone who starts their OAS at age 70. The answer is yes. Continue Reading…

Will the CRA eventually tax TFSAs?

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By Dale Roberts, Cutthecrapinvesting

Special to the Financial Independence Hub

As it stands today the Tax Free Savings Account or TFSA is true to its name. It is tax free on all counts. The interest or income or capital gains created in the account are not taxed. When you take money out of your TFSA you pay no tax. Net, net, your money grows tax free and you can spend it tax free.

But will this change in the future when Canadians have amassed considerable sums and are able to generate significant tax free income in retirement? Will the CRA eventually tax your Tax Free Savings Account? The TFSA program was launched in 2009 with a maximum of $5000 of contribution space. The contribution allowance has been increased to reflect inflation and now sits at $6000 annual.

In 2019 it’s not uncommon to see a Canadian who has maximized their TFSA contributions and who has invested their monies sitting with a six figure balance. In fact they might even approach a balance of $110,000 or more in a TFSA. For a Canadian couple that is $200,000 or more in potential tax free income.

In another 10 years that couple could easily have a combined $500,000 in TFSA monies. Of course they’ll need the cooperation of the stock markets that have been more than generous over the last 10 years, especially if you throw that roaring US stock market into the mix.

A massive TFSA gives Canadian retirees options

When Canadian retirees begin to accumulate sizable TFSA accounts they can start to execute some very opportunistic retirement strategies. And that might include accessing the government program known as the GIS or Guaranteed Income Supplement. That’s designed to help lower income seniors.

In a guest post on Cut The Crap Investing Financial Planner Graeme Hughes outlined how spending our own RRSP monies can negate potential GIS payments and that is one of the most common mistakes made by Canadian retirees. From that post …

What’s less well-known is the impact RRSPs can have on lower-income seniors, particularly those retiring with only the Canada Pension Plan (CPP) and Old Age Security (OAS) amounts for pensions. In many cases these seniors would also get the Guaranteed Income Supplement (GIS), which is an add-on benefit to the OAS. However, the GIS is an income-tested benefit and RRSP withdrawals absolutely count as income for this purpose.

So often I have seen seniors withdrawing from their modest RRSPs in retirement while not realizing that, had they not been making those withdrawals, they would have been receiving valuable GIS benefits rather than drawing down retirement savings. By better allocating their resources prior to retirement they could have greatly improved their overall retirement picture.

And that seems like fair and needed financial planning for those with modest RRSPs. That’s all within the spirit of the OAS and the GIS program that is designed for retirees with lower incomes. But Graeme goes on to outline that some retirees with greater assets can also take advantage of the GIS program by using their TFSA accounts.

Even for wealthier retirees with substantial savings but no employer pensions, it is possible to obtain 7 years of GIS benefits by drawing down TFSAs or savings between age 65 and 71 and letting the RRSPs grow until mandatory withdrawals start at age 72. Those benefits can be worth tens of thousands of dollars and should absolutely be taken into consideration when planning for retirement.

TFSA withdrawals do not show up on your tax filing as income. The CRA only keeps track of your TFSA contributions and withdrawals. And certainly make sure you understand how the program works so that you can avoid any over contribution penalties. Here’s a link to the TFSA essentials on the CRA site.

Given that, a retiree could take out $20,000 for spending from TFSA ($40,000 for a couple) and those monies do not count as income. Those retirees only source of reportable income might be CPP and OAS payments – they might qualify for GIS or reduced GIS. But these retirees are certainly lower income seniors. They may have an owned-home worth $1 million or more, each with RRSPs in the $500,000 range (or more), those six figure TFSAs and perhaps some taxable investment accounts throwing off tax efficient dividend income that qualifies for the Canadian dividend tax credit. They might have a modest amount in a savings account that is earning very little and not greatly affecting their income statement.

These retirees might have a net worth of $2,000,000 or more and yet they still qualify for that Guaranteed Income Supplement. When that occurs, it’s totally legal and within the current rules, but it’s certainly not within the spirit of the GIS program designed to help lower income seniors.

Will most Canadians be outraged?

I’m guessing that most Canadians will be up in arms when they hear or read of this opportunistic financial planning. Jonathan Chevreau asked the question on Twitter and it generated a vigorous debate. Well that is, readers were already taking issue with the potential use of GIS for those with considerable assets. Continue Reading…

How Real Return Bonds compare with regular Bonds, protecting against unexpected rises in Inflation

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Real Return Bonds (RRBs) pay you a rate of return that’s adjusted for inflation, but that’s not always as promising as it seems.

When a real-return bond is issued, the level of the consumer price index (CPI) on that date is applied to the bond. After that, both the principal and interest payments are typically adjusted every six months, upwards or downwards from that base level, to compensate for a rise or fall in the CPI.

In general, Government of Canada real-return bonds pay interest semi-annually, on June 1 and December 1.

How a real-return bond works: A theoretical example

The Bank of Canada issues $400 million of 30-year bonds maturing on December 1, 2049. The bonds have a coupon, or interest rate, of 2%.

If after six months from the date of issue, the new CPI level is, say, 1% above the level of the CPI on the issue date, then each $1,000 of bond principal is adjusted to $1,010 of bond principal ($1,000 x 1.01). The semi-annual interest payment is then $10.10 ($1,010 x 2% / 2).

If after 12 months, the level is 2% higher, then the bond principal is adjusted to $1,020 ($1,000 x 1.02), and the interest payment rises to $10.20 ($1,020 x 2% / 2).

Three important considerations to recognize with real-return bonds

1.) The price you pay for real-return bonds reflects the anticipated rate of inflation. In other words, if investors feel that inflation will rise 2% over the long term, the price of the bond will reflect that future inflation increase and its effect on the bond’s principal and interest payments. So, when you buy a real-return bond, you are only protecting yourself against unanticipated rises in inflation.

2.) When the inflation rate falls over a six-month period, the principal and interest payments of a real-return bond fall. In times of deflation, the inflation rate turns negative. In a prolonged period of deflation, the principal of a real-return bond could fall below the purchase price. Interest payments would fall, as well.

3.) As with regular bonds, holders of real-return bonds must pay tax on interest payments at the same rate as ordinary income. That income gets taxed at the investor’s marginal rate. In addition, holders of real-return bonds must also report the amount by which the inflation-adjusted principal rises each year, as interest income, even though you won’t receive that amount until the bond matures. That amount is added to the bond’s adjusted cost base.

If the CPI level falls, that reduces the inflation-adjusted principal. You deduct the amount of that reduction from your taxable interest income that year, and also subtract it from the adjusted cost base.

Real-return bonds in comparison to regular bonds

In simple terms, a bond is a form of lending whereby you lend money to a corporation or government. In return, a bond pays a fixed rate of interest during its life. Eventually, a bond matures, and holders get the bond’s face value—but nothing more. Receiving the fixed interest and face value at maturity is the best that can happen. Note, though, that in some cases, corporate bonds can go into default. As well, inflation can devastate the purchasing power of bonds and other fixed-return investments. Continue Reading…