Tax-Sheltered vs. After-Tax Assets
Until Chapter 21, all money saved for retirement was held in tax-assisted vehicles such as RRSPs, RRIFs, and LIFs. With one exception, any amounts saved were tax-deductible and the withdrawals after retirement were subject to income tax.
TFSAs were the exception, as contributions to a TFSA are not tax-deductible and the investment income is not subject to income tax, ever. When money is withdrawn from a TFSA, it is not deemed to be income at all and is therefore not subject to income tax or even the OAS clawback.
In Chapter 21, the Wongs had a source of retirement income — stocks and bonds — that fell outside of any tax-sheltered arrangement. The same was true of the Clarkes in Chapter 22.
Having assets is always a good thing, whether they are tax-sheltered or not, but non-tax-sheltered (NTS) assets add an extra dimension to the decumulation challenge. You must take into account the different tax treatment of each holding and decide when it is best to turn that asset into income.
Dividends and interest earned on NTS assets are taxable at different rates. Both are taxed annually while capital gains are taxable only when the investment is sold. If they had no capital gains on their investments, the Wongs could sell them and spend the proceeds without any tax consequences.
The table below summarizes how tax treatment varies depending on the savings vehicle that the withdrawals came from.
|
Source of the withdrawal |
Income tax treatment |
|
RRSP, RRIF, LIF, or annuity purchased with monies from an RRSP |
Taxed as ordinary income except a small amount is offset by the pension amount tax credit after age 65 |
|
TFSA |
Not subject to income tax, ever |
|
NTS assets in brokerage accounts, bank accounts, etc. |
Income tax is incurred on the profit if an investment is sold, not by withdrawal |
This brings up the burning question of what assets to cash out first in retirement. The goal with a decumulation strategy is to maximize one’s after-tax income rather than just maximizing income. Doing the latter doesn’t necessarily ensure the former.
Monies from after-tax assets (including a TFSA) generally go farther in retirement than monies from tax-sheltered vehicles. For instance, if your marginal tax rate in retirement is 33 percent, then one dollar of income from a TFSA is equivalent to $1.50 of income from a RRIF or a LIF.
All things being equal, you should withdraw your NTS assets first, except for your TFSA, where the investment income accumulates tax-free. Interest income and realized capital gains and losses on other NTS assets are taxable annually whereas the investment income within your RRIF, LIF, or RRSPs is not taxed until the money is withdrawn. Keeping your tax-sheltered monies intact for as long as possible is usually the best way to maximize the growth of your total assets, or at least to minimize net shrinkage.
There are exceptions to this simple rule. For one thing, you might have to sell some stocks or bonds in order to draw income from your NTS assets. If those investments include a large capital gain, selling them can trigger a big tax bill a lot sooner than you would like.
Another constraint is that you want to make maximum use of your tax credits because they do not carry forward. The tax credits I am referring to include the basic personal amount, the age amount, and the pension income amount. To take advantage of these credits, you need to ensure a certain amount of income is derived from tax-sheltered vehicles (not including your TFSA).
By the way, if you purchased an annuity with tax-sheltered assets when you retired (which was Enhancement 3), the annuity income is essentially the same, tax-wise, as withdrawing the money straight from a RRIF.
The OAS clawback presents another interesting wrinkle, assuming you have enough taxable income for it to be an issue. (See p. 147 for details.) If some of your OAS pension is getting clawed back because of your income level, you might consider deferring the start of OAS until 70 and drawing more of your income from other sources before then.
To sum up, you want to structure your withdrawals so that you (a) maximize the use of your tax credits, (b) minimize income tax payable on investment income from NTS assets, and (c) minimize income tax payable as a result of receiving income from your RRIF, LIF, or annuity.
If all that isn’t complicated enough, you also want to avoid a significant dip in your after-tax income at some point down the road. For example, say you draw all your income from NTS assets and your TFSA in your early retirement years. That might leave you only with your tax-sheltered assets to produce income in your later years. While that might produce the same amount of gross income, it would be taxed more heavily, resulting in a substantial decline in after-tax income.
For the purposes of the calculations in this book and PERC, I have assumed that income each year in retirement would come from a blend of all the various asset classes. This isn’t necessarily the most tax-efficient strategy, so if you have significant NTS and tax-sheltered assets, I suggest you have a discussion with your accountant about how best to draw them down.