We are often asked whether it makes sense to take more out of registered accounts earlier to reduce estate taxes. As so often is the case in financial planning, the answer is… it depends.
To answer this, we need to balance taxes paid from registered accounts and sustainable retirement income. Taxes from registered retirement accounts are punitive: any amount taken out is considered income and is fully taxable.
The first thing to consider is whether you want to pay more taxes now while alive or after you die. The next thing that needs to be considered is whether you can afford to pay more taxes now.
When we build retirement plans for clients, we use a robust process to ensure that the after-tax income in retirement is sustainable. When deciding whether to take more money out of registered accounts than is necessary to meet expense needs, individuals should look at what that does to their probability of success in retirement.
Let’s look at a couple in retirement and what factors they should consider.
Joan and Raul are in their late 60s. They have combined $2 million in RRIFs (Registered Retirement Income Funds), $1.5 million in a holding company, and $300k in TFSAs and non-registered assets. They do not have pensions outside of the Old Age Security and the Canada Pension Plan – where they are receiving $25,000 combined annually. They have undergone a budget exercise to understand their basic, discretionary and luxury expenses and know they need $120,000 in after-tax income for their current phase of retirement which is the most expensive phase. They are active, social and enjoy travelling. They still own their family home which is bigger than they need but they enjoy the space and the yard.
Joan and Raul have two children (both married) and one grandchild. They have discussed leaving money for their children and both agree that they would like to do this should their finances permit. A friend suggested that they consider actually taking more money out of their registered retirement accounts every year while in retirement rather than leave a bigger registered asset at death. The argument the friend put forth was that if they take more money out when alive, they pay more taxes at a lower rate when alive; however, their estate would avoid the more punitive higher taxes at death that would be applied to a large registered account after they both pass away. So ultimately he argued, they should be able to have a larger net-after tax estate for their children.
Should Joan and Raul take out more funds from their registered retirement income funds now, paying more in taxes over the next few years to potentially leave more for their beneficiaries?
There are a few variable factors they should consider.
- Sustainability: How sustainable is their retirement income without accelerating the extra payments and extra tax? If the retirement plan today has a lower probability of success, Joan and Raul should be more concerned about running out of money, and less so about ensuring the tax-efficient transfer of funds to their beneficiaries.
When we run our Retirement VIEW software, we look for a 95% probability of success. That means that there would be a 5% probability of the retiree running out of money prior to assumed mortality. This is a risk that most retirees are willing to take.
By withdrawing extra income out of their portfolio today, Joan and Raul face an 80% probability of success; they may not want to take a 1 in 5 chance of running out of money in order to leave more money for their children. - Longevity: According to the Canadian Institute of Actuaries (2007), if a couple is 65 years old, they have a 50% chance that one of them will live to age 90. When we look at retirement income, it is important to factor in longevity. We often use the age of 95 as a reasonable planning assumption for mortality. The longer you live in retirement, the greater the risk to your retirement income. If there is longevity in the family, protecting assets for sustained income will play a more important factor in deciding the above.
- Marital status: When someone passes away with registered assets, the surviving spouse can receive those assets on a tax-free basis. It is only upon death of the second spouse that the assets will be taxable. During retirement life, having a spouse can also allow for pension splitting which can effectively reduce overall taxes and make the strategy to withdraw more from registered retirement accounts earlier more attractive.
- Tax brackets today: If retirees are paying higher taxes today because, for example, they already have a generous pension, or their income needs are high in retirement, taking more money out of a registered account at a high tax rate does not make much sense.
- Old Age Security: This pension starts getting clawed back when annual net income is greater than $77,580 (for 2019 income); and is fully clawed back when annual net income reaches $126,058. Making sure OAS is not lost and that income is kept below this claw-back zone can be another factor to consider.
- Dependency: Having individuals that are dependent on an inheritance can also factor into the equation. If Joan and Raul have a child that is physically or mentally dependent on their income, they may need to ensure that a certain amount is left for them. Life insurance may be a more suitable solution (if Joan and Raul are insurable) and different planning needs to be put in place for a family faced with this kind of situation.
Joan and Raul will need to first assess whether their retirement plan has a high probability of success without taking more funds out of their registered retirement accounts. If they do have a high probability of success, they should then look at spreading out taxes to take advantage of lower taxes when in retirement to see the net impact on their estate. As described above there are many other factors to consider before putting a plan in place. What may make sense one year, may not the next as circumstances change. Market corrections, increased unexpected expenses, the loss of a spouse, family dynamics, and changes in tax rates are all potential reasons to have to adjust the direction of the plan. Having a retirement plan that is actively managed and nimble is paramount when planning for today and the future.
At Tall Oak Private Wealth, we help clients manage their retirement reality by working with them on their individual Retirement VIEW. We look forward to continuing conversations with you as we help you plan your retirement.
The views expressed in this commentary are those of Tall Oak Capital Advisors as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice. Statistics, factual data and other information are from sources Tall Oak believes to be reliable but their accuracy cannot be guaranteed. This commentary is intended for distribution only in those jurisdictions where Tall Oak Capital Advisors are registered. Securities-related products and services are offered through Raymond James Correspondent Services Ltd., member Canadian Investor Protection Fund. Insurance products and services are offered through Gryphin Advantage Inc., which is not a member-Canadian Investor Protection Fund. This commentary may provide links to other Internet sites for the convenience of users. Tall Oak Capital Advisors is not responsible for the availability or content of these external sites, nor does Tall Oak Capital Advisors endorse, warrant or guarantee the products, services or information described or offered at these other Internet sites. Users cannot assume that the external sites will abide by the same Privacy Policy which Tall Oak Capital Advisors adheres to.
