One of the most important decisions a retiree must make is how to create an income and cash-flow strategy from the financial assets they have accumulated over their lifetime.
This can be challenging as you may have numerous sources of potential cash flow such as:
- Old Age Security and Canada Pension Plan
- Company pension plans
- RRSPs, RRIFs, Locked in RRSPs
- Tax free savings accounts (TFSAs)
- Annuities and guaranteed income products
- Non-registered investment accounts
- HOLDCOs
Each of the above cash-flow sources can have different start dates and a retired couple could easily have to decide on how and when to start the income or cash flow from 6 to 12 sources or more.
Why is this important?
Your income and cashflow strategy will affect your:
- income and cashflow spending today
- the tax you pay today, and in the future
- availability of government income credits and benefits over time
- how long your investment assets will last
- success rate of your plan
- our estimated estate value for the next generation
Income vs Cashflow
In retirement, there is a difference between income and cashflow. The reason is different sources of income are taxed differently and have a different effect on your after-tax cashflow.
What you should focus on is how much money you need going monthly into your bank account, similar to your paycheque when working.
What is the Process?
The process to develop an ongoing tax effective income and cash-flow plan is as follows:
- Review your cash flow sources and start dates.
- Create an Order of Withdrawal or Account Sequencing strategy.
- Asset Location and Deployment strategy
- Annual Adjustments
REVIEW CASH FLOW SOURCES AND START DATES
The following is a list of the potential cashflow sources that should be reviewed and confirmed. The sources are divided into reliable income such as government plans, and variable sources of income from your own savings.
Reliable Sources of Income
Canada Pension Plan: earliest start is age 60 and can be delayed until age 70.
Old Age Security: earliest start age is age 65 and can be delayed until age 70.
Company Pension Plans: defined within the plan.
Annuities: normally when purchased.
Guaranteed Income Products: normally will have a minimum age to start.
Variable Sources of Income
RRSPs: You can start income at any age (convert to a RRIF) but must be converted to an income plan (RRIF) or annuity by the end of the year you turn 71 and you then must start the minimum withdrawals the following year.
Locked-in RRSP: Normally you must wait until age 55 to start an income, but it must be converted to an income plan (i.e., LIF) or annuity by the end of the year you turn 71, and you must then start the minimum withdrawals the following year.
Non-Registered Investment Accounts: Income and withdrawals can be started at any time.
HOLDCOs: If you owned a company, you might have an investment account in a holding company (HOLDCO). It can normally be accessed at any time.
Taxation of Retirement Accounts
There are three main types of accounts in retirement:
Taxable: These would be non-registered investments. Income is taxable each year as earned in the form of interest, dividends, or capital gains. Capital gains and dividends are tax preferred, and interest income is taxed at the highest rate.
Tax-Deferred: These would be registered plans (i.e., RRSPs, LIRAs). You do not pay any income tax on the income earned each year within the plan, however once you start to take payments, the income is treated as 100% taxable income.
Non-Taxable: This would be a Tax-Free Savings Account (TFSA). You do not pay any income tax on the income earned within the plan, or when you take money out of the plan—it is “Tax-Free.”
ORDER OF WITHDRAWAL STRATEGIES
An order of withdrawal strategy means the decision on when you start to take an income from the various sources. With 6 to 12 sources of income, you can have various withdrawal strategies to review.
You will want to model the various strategies as each one will have a different effect on the taxes you have to pay today, and the amount of taxes in your estate in the future.
Initial Order of Withdrawal Strategies:
-
Taxable – Tax Free – Tax Deferred (RRSPs/RRIFS)
- You would draw an income from your reliable sources and non-registered investments first.
- The next source would be your TFSAs.
- You would delay the conversion of your registered investments (RRSPs, LIRA) to RRIFs (income) if you can.
-
Tax Deferred (RRSPs/RRIFs) – Taxable – Tax Free
- At retirement you would convert your Registered Investments to income plans such as RRIFs/LIFs, as well draw on your reliable sources of income.
- The next source would be your non-registered accounts.
- The last source would be your TFSAs if needed.
-
Blended Withdrawals
- You would draw an equal amount from your registered investments and non-registered investments.
-
Custom – Partial RRSP Conversions
- You would start your sources of reliable income.
- You would convert some of your registered plans to income plans, and delay some to age 71 based on the income tax bracket.
-
This is a more customized approach based on tax bracket management.
You will also want to model the effect on your plans by delaying the start date of your Canada Pension Plan (CPP) to determine the effect on your income plan, taxes, success rate and estate values of your plan.
Tax Bracket Management
In Canada we have a marginal tax rate system which means as you earn more income, the tax you pay on each additional dollar increases. Part of what you should examine is the marginal tax rates over time, and if there are any strategies to even out between spouses or common-law partners (CLP’s)
You will want to specifically review the effects at:
- age 65, when you start to receive OAS
- age 71, or when you must convert your RRSPs to RRIFs
If you find you are in the OAS clawback zone at age 65 or 71, you may want to fill up the “tax buckets” when you have lower income years to reduce or eliminate it.
Taxes Today vs Taxes in Your Estate
In reviewing the options, often it can come down to balancing short- and long-term tax efficiency as follows:
- Paying less tax today and leaving more tax to be paid by your estate.
- Paying more tax today, and less tax in your estate.
When you defer the conversion of RRSPs to RRIFs it creates a larger account value, and on the death of the last spouse or CLP, any assets remaining in the plan are taxed as 100% income in the year of death.
The key advantages of deferring the conversion of your registered investments to income plans is that it puts less stress on your own investments in the first several years of retirement, and this will help to preserve your own assets longer.
This strategy should be reviewed annually, and over time you may start to fill up the lower “tax buckets” and reduce potential tax in your estate as part of an RRIF exit plan.
A current strategy we are using with the low interest rate environment is to use the TFSAs as a long-term and estate account. TFSAs are an effective tool for estate transfer as you can name a beneficiary and no tax is paid on the transfer.
Cash Flow Based Financial Planning Software
Fortunately, we can model the options using our financial planning software as it will project and compare:
- After tax cashflow
- Taxes
- Success rate of the plan
- Estate value
ASSET LOCATION AND DEPLOYMENT
Once you have developed your retirement portfolio allocation among fixed income, dividend, and capital gains investments, you must decide where to place them.
Historically, investors would place their investments as follows:
Taxable Accounts: investments that generate capital gains and dividends, as these are tax preferred.
Tax Deferred Accounts: fixed income investments (RRSPs, RRIFs)
Non-Taxable Accounts: fixed income investments (TFSAs)
In the past, when fixed income earned returns of 5-7%, it made sense to tax shelter the income as the investment would compound at a good rate.
However, with today’s low interest rate environment, it doesn’t make sense to place an investment in an RRSP/RRIF or TFSA that can compound tax free at 1-3 % for several years.
The strategy we recommend is to compare the effect on the plan by reviewing deploying the investments by:
- Historical approach like above
- Mirrored accounts, where the same investment asset allocation is in both taxable and tax deferred accounts.
Using our cashflow based financial planning program, we can compare the effect over time on taxes, spending, success rate, and the estate value of the plan options.
ANNUAL ADJUSTMENTS
Each year the process must be repeated to adjust for changes in:
- Income requirements
- Tax changes
- Age
- Strategy changes
Some of the annual review items include:
- Is your spending rate still sustainable?
- Can you spend more?
- Should you withdraw more taxable income?
- Review tax splitting planning strategies.
- Review the plan’s effect on income benefits and credits.
- Effects of lump sum withdrawals, and the best source
- Review the OAS claw back.
- Review the asset location and deployment.
- Should the source of income be adjusted?
- Tax planning for TFSA top ups.
- Tax planning for non-registered investments.
- Are the investments still tax effective?
- Moving corporate investments to personal investments.
- Reviewing the estate plan.
Summary
Creating tax-effective income and cashflow is an ongoing process over retirement as follows:
- Review your cash flow sources and start dates.
- Create an Order of Withdrawal or Account Sequencing strategy.
- Asset Location and Deployment strategy
- Annual Adjustments
Not only is the initial strategy important, but the annual adjustments are even more critical to keep people on track to maximize their retirement income and cashflow with the inevitable changes in families’ lives over time.
For more information, you can refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®
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Jack Lumsden, MBA CFP® Financial Advisor, Assante Financial Management Ltd.
This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The information provided is for illustrative purposes only. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.
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