By Bob Lai, Tawcan
Special to the Financial Independence Hub
As many of you know, we have been busy adding new capital and buying dividend paying stocks over the last few years. During the COVID-19-caused short recession last year, our portfolio was down as much as $250,000. We didn’t panic and liquidate our portfolio. Instead, we saw the recession as an opportunity to buy discounted stocks and we added $115k to our dividend portfolio.
I’m a believer in time in the market, rather than timing the market. Therefore, we try to be fully invested in the stock market as much as we can. We use our monthly savings to add new shares and take advantage of any downturns. We also strategically move any long term savings for spending account to buy dividend paying stocks whenever there are enticing buying opportunities. We then “put back” money in the LTSS account over time.
Although we are in the accumulation phase of our financial independence retire early journey, I have done a few calculations and scenarios to plan out our early withdrawal strategies and plans. But they are what the names suggested – strategies and plans. Nothing is written in stone and things can certainly change by the time we decide to live off our dividend portfolio.
Recently Mark from My Own Advisor appeared on Explore FI Canada to discuss FI Drawdown Strategies. Since Mark is a few years ahead on the FIRE journey than us, or FIWOOT (Financial Independence Working on Own Terms) as Mark calls it, it was great to hear about what Mark is thinking and the considerations he has.
Speaking of living off dividends and early withdrawal strategies, it was really awesome to be able to pick on Reader B’s brain on this topic:
- Living off dividends – How I’m receiving $360k dividends a year & paying almost no taxes
- Living off dividends – My $360k per year dividend income
After listening to the Explore FI Canada episode, I thought about our early withdrawal strategies. Are there effective ways to minimize taxes so we get to keep more money in our pocket?
For Canadians, we can receive CPP and OAS when at age 65. I have not included CPP and OAS in our FIRE number calculation because I always considered them as the extra income and didn’t want to rely on them during retirement. Having said that, are there things we can do to receive the full CPP and OAS amounts without clawbacks?
A few things to note before I go any further…
- We plan to live off dividends and only sell our principal if we absolutely have to.
- We plan to pass down our portfolio to our kids, future generations, and leave a lasting legacy.
- Ideally it’d be great to be able to pass down our portfolio to future generations. But we also don’t want them to take money for granted. Therefore, we are also not against the idea of not passing anything to future generations.
- I’d love to write a million dollar cheque and donate it to a charity.
Our Investment Accounts
Our dividend portfolio comprises the following accounts:
- 2x RRSP
- 2x TFSA
- 2x taxable accounts
I also have an RRSP account through work. Every year I have been moving my contribution portion to my self-directed RRSP at Questrade. I can’t touch my employer’s contribution portion until I leave the company.
Neither Mrs. T nor I have work pensions so that may make the math slightly simpler.
The only complication I need to consider is what to do with income from this blog. This blog now makes a small amount of money. For tax efficiency, it might make sense to consider incorporating. Many bloggers I know have gone down this route for tax efficiency reasons. This is something I will have to consult with a tax specialist in the near future and crunch out some numbers to see what makes the most sense.
As the name suggests, the RRSP is a great retirement savings vehicle. But there are three important caveats people often skim over:
- RRSPs must be matured by December 31 of the year you turn 71. You can convert an RRSP into a RRIF or purchase an annuity. Most people convert their RRPs into RRIFs.
- A RRIF has a mandatory minimum withdrawal rate each year.
- The minimum withdrawal rate increases each year (5.4% at age 72 and jumps to 6.82% at age 80).
- RRSP and RRIF withdrawals are counted as normal income and taxed at your marginal tax rate.
Personally, I don’t like the restrictive nature of the RRIF. Imagine having $500,000 in your RRIF and having to withdraw a minimum of $27,000 at 72. If your RRSP/RRIF has a bigger value, it means you are forced to make a bigger withdrawal!
By plugging the amount currently in our RRSPs into a simple RRSP compound calculator, assuming no more contributions and an annualized return of 7%, I discovered that we’d end up with more than $2M in each of our RRSP!
At 5.4% minimum withdrawal rate, that means we’d have to withdraw at least $108,0000 each. This would then put both of us into the third federal tax bracket. More importantly, we’d get hit with OAS clawback (more on that shortly).
Therefore, it makes sense for Mrs. T and me to consider early RRSP withdrawals and perhaps consider collapsing our RRSP before we turn 71.
Contrary to many Canadian beliefs, there are no clawbacks for CPP.
You pay into the Canada Pension Plan (CPP) with your paycheques. Each year that you contribute to the CPP will increase your retirement income. Therefore, the amount of CPP you will receive at 65 depends on your contributions during your working life.
In 2021, the maximum CPP benefit at age 65 is $14,445.00 annually or $1203.75 monthly. The CPP benefit is taxed at your marginal tax rate.
But not everyone will get the maximum CPP amount since it is based on how long and how much you pay into the CPP.
- You must contribute to CPP for at least 83% of the CPP eligible contribution time to get the maximum benefit. You are eligible to contribute to CPP from 18 to 65, so 83% would mean you need to contribute to CPP for at least 39 years.
- In addition, you also need to contribute CPP’s yearly maximum pensionable earnings (YMPE) for 39 years to qualify for the maximum CPP amount. For 2021, the YMPE is $61,600.
Not many people can meet these two requirements, hence the average CPP payment received in 2020 was $689.17 per month or $8,270.04 annually.
Since we plan to “retire early” eventually, it’s unlikely that we will qualify for the maximum CPP benefits.
Unlike the CPP, there are clawbacks or a pension recovery tax for OAS. If your income is over a certain level, the OAS payments are reduced by 15% for every dollar of net income above the threshold. In 2021, the OAS clawback threshold starts at $79,845 and maxes at $129,260. So, if you’re making over $79,845, you will receive reduced OAS payments. And if you’re lucky enough to have a retirement income of over $129,260, you get $0 OAS payments.
You can start receiving OAS as early as the month following your 65th birthday but you can increase the amount of your benefit if you delay your OAS payment up to age 70. For each month you wait to start your OAS pension, your pension amount will go up by 0.6%. This may not sound a lot, but by delaying OAS by a year, you will increase your OAS payment by 7.2%. If you delay by five years, you’d increase the amount by 36%.
From April to June 2021, the current maximum OAS amount is $618.45 monthly or $7,421.40 annually. If you delay OAS until age 70, this amount increases to $841.09 monthly or $10,093.08. Therefore, it makes sense to delay OAS until age 70 if you don’t need the money.
Like CPP, OAS is taxable.
One important thing to note is you need to reside in Canada for at least 40 years after you turn 18 to receive the full OAS amount. If you haven’t lived in Canada for at least 40 years, you are still eligible for partial OAS payments.
Since Mrs. T became a Canadian permanent resident in her late 20s and we plan to live abroad (i.e. geoarbitrage) for several years in the future, it is highly possible we won’t receive the full OAS payments.
But that’s OK because we have never counted OAS to fund our retirement.
Our early withdrawal strategies
Here are some early withdrawal strategies I have in mind. While I have done some research, I have not consulted with tax specialists, so I am always open to ideas and suggestions.
- Before age 65, withdraw from RRSPs early. Withdrawals from RRSPs count as working income, so we want to keep the withdrawal amount to less than $15,000 per person if possible. We’d get hit by a 20% withholding tax but we should be able to recover most of that tax when filing tax returns.
- The money from the yearly early RRSP withdrawals can either go into our TFSA for tax-free compounding or buy dividend paying stocks in taxable accounts to take advantage of the favourable dividend income treatment. Since income from RRIF is taxed as working income as your marginal tax rate, by my calculation, it is tax advantageous to collapse our RRSP before age 71 so we are not forced to withdraw a certain percentage from RRIFs each year.
- Before age 65, use dividends from taxable accounts. Dividend income from taxable accounts is very tax efficient as eligible dividend income up to $49,020 is tax free (5.4% up to $42,184 for British Columbians). One thing we need to keep in mind is that eligible dividends are grossed up by 38%.
- To avoid big capital gains when we do eventually pass down our portfolio, in “lower” income years, we may consider selling our dividend stocks in taxable accounts then buy back the stocks. Essentially, spreading capital gains across multiple lower income years and “increase” the adjusted cost basis. This strategy may have significant tax consequences that I may not have considered, so I probably need to consult with a tax specialist. This idea is kind of the opposite of tax loss harvest.
- To take advantage of the compounding effect, we plan to delay withdrawing from TFSAs for as long as possible. Since withdrawals from TFSA are not taxable income, TFSA is an extremely useful account in retirement years. Check out The Millennial’s Ultimate TFSA Guide.
- We plan to delay OAS until age 70. We will get partial CPP payments at age 65.
When we live off dividends initially (i.e. 40s and/or 50s), it is most likely that we will have income from either part-time jobs and/or our side hustles. So further calculations are required to determine maximum tax efficiency. And since our tax situations will probably change, we need to remain flexible with our early withdrawal plans.
If I decide to incorporate this blog and open a corporate investment account, I’d fully invest the income. Later on, I’d pay myself dividends rather than salaries to avoid dealing with CPP and EI payments. This would also avoid creating RRSP contribution rooms and potentially creating more headaches down the road. Overall, dividends from a corporation appear to be more tax efficient than salaries.
But since the blog income is not a guarantee, I might just leave the blog as a sole proprietor and file everything under personal income for simplicity’s sake.
Things to work on
We plan to split income equally when we live off our investments. But a 50-50 split may not be possible because Mrs. T is currently not working full time. With that in mind, here are a few things we can work on to try to split income equally in the future:
- Continue to maximize both of our TFSAs each year. Mrs. T had contributed $10k less in her TFSA because she didn’t become a Canadian permanent resident until 2011.
- After working for 15 years at the company, I have a head start in RRSP compared to Mrs. T. A few years ago, we opened a spousal RRSP and stopped contributing to my self-directed RRSP (I still contribute to my work RRSP though). Right now, my RRSP is about three times the value of Mrs. T’s spousal RRSP. The goal is to have our RRSPs at roughly the same value so we can make withdrawals about the same dollar amount each year.
- Since I’m in a higher tax bracket than Mrs. T, I can loan money to Mrs. T to invest in her taxable account. The prescribed interest rate for spousal loans is 1%. The loan method may allow us to have a roughly equal taxable account portfolio value.
- For my work RRSP, when I can touch my employer’s portion, I may decide to withdraw the full amount over a number of years and loan that money to Mrs. T for her taxable account (need to consult with a tax specialist about this).
The goal is to split our income in the future to minimize taxes and keep more money in our pocket. As you can see, more tweaks are needed.
Summary – Our Early Withdrawal Strategies
When it comes to our early withdrawal strategies, there are a lot of numbers, factors, and scenarios to consider. Our early withdrawal strategies aren’t 100% firm because we know things can change. We can always change our strategies and plans as we see fit. After all, having plans and strategies is a lot better than having nothing at all.
Dear readers, do you have any suggestions for our early withdrawal strategies? Did I overlook anything?