Planning for taxes in retirement is like putting together a puzzle that is specific to each retiree. The type of income determines how it is taxed.
Each year in retirement this must be reviewed to determine what is the best strategy that balances your current year’s income, and your long-term legacy plan.
It is a puzzle that must be put together each year.
- The four key sources of income and how they are taxed
- The types of income in each
THE FOUR TYPES OF INCOME
- Taxable income
- Tax-deferred income
- Tax-free income
- Tax preferred income
This is income that is 100% taxable as it is received (called ordinary income). The sources of this type of income would include:
- Canada Pension Plan
- Old Age Security
- Pension Plan Income
- RRIF and LIF Income
- Employment income
- Interest Income
The income from these sources is taxed much like your salary while working, it is all considered taxable income.
This would be income that you currently do not pay tax on, but at some point in the future, you will have to pay tax on it. Sources include:
- RPPs and group saving plans
- Deferred capital gains
With registered plans such as RRSPs/LIRAs and group savings plans, you don’t have to pay tax on the income as it is earned, but when you convert the income plan and take out the minimum annual payments, then the income is taxable.
For capital gains, you do not pay any income tax until you realize the gain. As an example, say you purchased a mutual fund for two years for $10,000, and the current value today is $ 12,000. The gain is $2,000 today, but you would not have to pay tax on that gain until you sell the fund.
Tax-free income is income that you do not pay tax on. The two key sources would include:
- Tax-Free Savings Accounts (TFSA)
- Return of Capital (ROC)
With TFSA’s, you do not pay any tax on the income that is earned within the plan, or when you take the money out. It is all tax-free.
Return of capital (ROC) is your own money being returned to you. For example, let’s say you invested $10,000 into a mutual fund and the current value is $12,000 and you sell it. The original $10,000 you invested is your own money coming back to you, so no tax is paid. You would only pay tax on the $2,000 capital gain.
TAX PREFERRED INCOME
Tax preferred income is income that you must tax on, however, it is at a lower (better) tax rate than interest on ordinary income (i.e., RRIF Income, Pension, CPP/OAS, and salary). This can include:
- Capital Gains
- Eligible Dividend Income
- Prescribed Annuities
- Income Strategies
– Systematic Withdrawal Plans (SWPs)
– T- Series Funds
Capital Gains and Eligible Dividend Income
For investments that are not in registered plans, the preferred sources of income would be capital gains and dividend income. The reason is capital gain income and eligible dividend income is taxed less than interest income.
As an example, at the top marginal tax rates in Ontario you would pay the following tax on the income as it is earned:
- Interest and regular income 53.53%
- Eligible Dividends 39.34%
- Capital Gains 26.77%
Subject to specific conditions, if you purchase an annuity with non-registered investments, it could be considered a ‘prescribed annuity’, and the taxable income is spread out over your projected lifespan.
Systematic Withdrawal Plans (SWP)
A Systematic Withdrawal Plan (SWP) is an income strategy that can be used to generate monthly income from non-registered investments.
Monthly, a specific dollar amount is sold and deposited into your bank account.
The income deposited is tax effective as the payments are a blend of interest, favourably taxed dividends and capital gains, and non-taxable return of capital.
T-series are a class of mutual funds that can be used in a tax-effective income plan.
The strategy is like an SWP plan, as monthly a specific dollar amount is sold and deposited to your bank account.
T-Series Funds tend to allow a greater portion of the income you take each year to be considered return of capital (ROC), so less tax is payable.
STRUCTURE YOUR INCOME TO BE TAX-EFFECTIVE
Each year in retirement, you must reassemble your retirement income puzzle and review the four types of income to see what is best for you:
- Taxable income
- Tax-deferred income
- Tax-free income
- Tax Preferred income
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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