Thursday, November 26, 2009

RRSPs and the GIS Don’t Mix Well

Canadian seniors with low incomes receive a Guaranteed Income Supplement (GIS) from the government. Within a certain income range, each additional dollar of income reduces the GIS payments by 50 cents. This amounts to a 50% tax on this income. Combining this with the regular income taxes, the effective tax rate on RRSP withdrawals can be over 70%.

When Canadians draw money from a registered plan (RRSP, RRIF, or a registered annuity), the payment counts as income for tax purposes. Low-income seniors who collect the GIS may end up keeping only a small fraction of their registered plan withdrawals. I have looked at some test cases to try to come up with a strategy to keep more of the money.

Be warned that my analysis is based on a number of assumptions that may prove to be false. At the end of this post I outline some of the reasons why this analysis may have to be modified.

Basic Scenario

Annie is a single 71-year old living in Ontario collecting Old-Age Security (OAS) of $6203.52 per year. She has additional income from the Canada Pension Plan (CPP) and other sources (we’ll look at scenarios for additional income of $0, $5000, and $10,000). She has $100,000 in an RRIF and has to withdraw at least $7380 next year (according to the minimum RRIF withdrawal rate rules).

Case 1: Non-OAS income of $0

The entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.

Case 2: Non-OAS income of $5000

Once again the entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.

Case 3: Non-OAS income of $10,000

Only $5660 of the $7380 withdrawal will cause GIS clawback. Annie’s tax rate on the first $5660 is 71.05% and is 21.05% on the rest. She gets to keep $2996.51 of the withdrawal.

None of these scenarios is very appealing because Annie is losing too much of her savings to taxes and the clawback. A possible strategy for Annie is to withdraw more than the minimum and put the excess in a TFSA. The idea is that most of the excess wouldn’t cause any clawback and she would keep a higher percentage of it. In future years when Annie’s RRIF is drained, she can live on her TFSA.

It seems unlikely that Annie should withdraw the whole $100,000 in one year. For one thing she won’t have enough TFSA room. Other problems are the higher marginal tax rates for such a high income and the 15% OAS clawback that begins at income $66,325. So, I looked for the withdrawal amount that leads to the lowest percentage of tax plus clawback.

Here are the results based on Ontario marginal tax rates:

Case 1: Non-OAS income of $0

If Annie withdraws $60,132 per year from her RRIF her percentage of taxes plus clawback will be 38.6%.

Case 2: Non-OAS income of $5000

If Annie withdraws $55,132 per year from her RRIF her percentage of taxes plus clawback will be 35.7%.

Case 3: Non-OAS income of $10,000

If Annie withdraws $48,679 per year from her RRIF her percentage of taxes plus clawback will be 32.1%.

In cases 1 and 2, the optimum withdrawal amount was just short of the start of the OAS clawback. In case 3, the optimum point was just a little less than this. Once the RRIF is drained, she can collect the GIS and live on the money transferred to her TFSA (assuming she has sufficient TFSA room by the time she begins draining the RRIF).

Warnings

There are a number of reasons why this analysis may give the wrong answer for you:

1. I may have overlooked some important considerations.
2. You are not single or don’t live in Ontario.
3. Tax rules may change in the future (such as TFSA income contributing to GIS clawback).
4. You may not have enough TFSA room for excess withdrawals and end up having GIS clawed away by income from non-registered savings.
5. Other age-tested benefits actually make the total clawback higher than 50%.
6. I have assumed that a large income would eliminate GIS payments for only one year. If they actually cause the loss of GIS payments for more or less than one year, then the analysis changes.

This whole issue is complex enough that it seems unlikely that many low-income Canadians will succeed in minimizing the taxes on their registered savings.

21 comments:

  1. This shows that low income Canadians should prefer the TFSA (assuming withdrawals are exempt from taxable income in the future), paying down debt or taxable savings instead of a RRSP. They won't get much of a tax deferral in their working years (as their taxes are already low) and they will be paying high marginal rates on withdrawals in their senior years.

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  2. CC: That's right. For people who have enough lead time, it makes sense to shift to a TFSA. Unfortunately Many Canadians are already near retirement with hard-earned money sitting in an RRSP that may be destined to be taxed away.

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  3. I wondered how prevalent it is for a low-income household to have significant RRSP assets. I found this study on Stats Can:

    http://www.statcan.gc.ca/pub/75-001-x/2008102/pdf/10520-eng.pdf

    It seems to me likely that there are not many seniors like Annie who receive GIS and have significant RRSP assets. Only 35% of low income Canadians even have a RRSP and among those who do, the median value is just $10,000.

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  4. CC: So, we can conclude that about 1 in 6 seniors who collect the GIS have RRSP assets over $10,000. This still represents a large number of people and for them the clawback problem is very real. Keep in mind as well that $10,000 may not be much to wealthier people, but to someone who collects the GIS, this is a substantial sum. Losing over 70% of it is painful.

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  5. "So, we can conclude that about 1 in 6 seniors who collect the GIS have RRSP assets over $10,000."

    Not really. But we can conclude that 1 in 6 households with after-tax income of $36K or less have RRSP assets over $10K. Only a subset of these families will be seniors collecting just OAS and receiving GIS. I don't know what that subset is but I'm guessing it is a fraction of that 1 in 6.

    I do agree that for those who have this problem, it sounds like an unfair marginal rate on what is a very low income.

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  6. CC: I took a look at the document you pointed to and I see that I misunderstood your previous comment. I did find a document stating that 1.4 million Canadians collected the GIS in 2006. Even if only 5% had RRSP assets over $10,000, that would be 70,000 people. Presumably, the number who have $50,000 in RRSP assets is still more than the number of people who read my blog :-)

    I'm actually not that concerned with whether this whole business is fair or not. Because I have extended family members in this boat, I've been trying to figure out the best strategy to allow them to keep as much of their RRSP money as possible.

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  7. Wow. 1.4 million collecting GIS is a large number. It must be a significant proportion of the senior population. So, yes, it is possible that tens of thousands are faced with this problem.

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  8. Using a TFSA as soon as possible seems the best bet. ...
    Found the research paper by some Swedes titled Negative Effects of the Canadian GIS Clawback and Possible Mitigating Effects (http://econpapers.repec.org/paper/mcmsedapp/239.htm), which says the situation is even worse than you state, Michael: "savings in an RRSP can effectively be taxed at more than 100% through corresponding reductions in the GIS, social housing, home care, GAINS (Ontario's Guaranteed Annual Income Supplement), and other benefits which are based on one's personal retirement income." Yikes!

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  9. Interesting post - while it's great to save in rrsps - if you are going to be eligible for GIS then you are probably better off keeping your money in an open accounts (and TFSA). The problem is that I'm not sure how many GIS recipients plan to be GIS recipients (or do they plan at all?).

    FYI - You have to convert any rrsp accounts to rrif accounts by the end of the year in which you turn 71. You don't need to make a withdrawal in that year. So it's actually the year you turn 72 where you are "forced" to make your first withdrawal.

    I think for low-income Canadians (who end up with GIS) the TFSA is nice but even an open account is fine because of their low marginal tax rate.

    I have a friend who parents are in this situation - they ended up with about $100k in rrsps each even though they are eligible for almost the maximum in GIS. They ended up doing a meltdown where they withdrew it all over 3 or 4 years.

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  10. Canadian Investor: You're right about the real clawback being higher than 50%. It's hard to quantify these things because it depends on the seniors' health and where they live, etc. This just makes the need to draw out the RRSP more compelling.

    Four Pillars: Thanks for pointing out the fact that we don't have to draw from RRIFs until we're 72. I changed "this year" to "next year".

    I think many people who are destined to be GIS recipients are headed there whether they plan well or not. If a person can't get a job with benefits that include a pension, then they are headed for a retirement based on OAS and CPP. These people will collect GIS if they have little or no investment income. If they can structure their investments to not give taxable income (think TFSA), then they will collect the GIS. So good planning can actually be the cause of collecting the GIS.

    I'll give you a do-over on "for low-income Canadians (who end up with GIS) the TFSA is nice but even an open account is fine because of their low marginal tax rate." Once the clawback is taken into account, the marginal rate for GIS recipients is very high.

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  11. I'll pass on the do-over. :)

    I should have clarified that what I was getting at was that for someone who is low income and destined for GIS payments - that person would be far, far better off with either an open account or TFSA rather than an RRSP.

    Yes, the TFSA is better than the open account (and should be the first choice) but compared to an RRSP - the difference between the TFSA and open account is relatively small.

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  12. Four Pillars: I see where you're heading, but I see it a little differently. We are comparing a lump sum in one of a cash account, a TFSA, or an RRSP (that has been converted to an RRIF). Let's suppose that the investor must withdraw an amount from the RRIF that represents double the actual investment return each year. Then the tax impact of the RRIF withdrawal will be about double the impact of having the money in a cash account. The TFSA is the best choice, and the cash account is about in the middle. If we add in the fact that the lump sum in an RRIF will actually be larger because it was filled with pre-tax money each year, the difference between an RRIF and the cash account becomes smaller. I'd say that in most circumstances, the step from RRIF to a cash account has about the same value as the step from a cash account to a TFSA. So, I'd definitely recommend that low-income Canadians use a TFSA instead of a cash account.

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  13. Michael,

    First off thanks for this post (as well as your blog in general).
    I'm very interested in your analysis. Due to unplanned life circumstances my mother is in this very situation, with virtually no pension income other than OAS. She'll be living off what savings she does have -- both RSP and non-registered -- so GIS clawback due to an RRIF is a big consideration.

    I'm wondering where you got the information to calculate the GIS clawback for different income levels? (And the math for optimizing it?)
    I'd like to look at the possible scenarios for my mom, so any further details you can provide would be appreciated!

    thanks,
    Daryn.

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  14. Daryn: The web page with information about GIS benefit levels and how they are affected by income is here:

    http://www.hrsdc.gc.ca/eng/isp/oas/tabrates/tabmain.shtml

    There are many places to get marginal tax rates. Here is an example for Ontario:

    http://www.investinontario.com/siteselector/bctx_606.asp

    The math for optimizing RRSP (or RRIF) withdrawals I used was to minimize the percentage of tax plus GIS clawback. Suppose you are considering a $10,000 withdrawal and the taxes plus clawback will be $2500. This is 25%. If the next dollar withdrawn will be taxed at only 21% (with no additional clawback), then it makes sense to keep withdrawing more until the next dollar withdrawn doesn't help. This is based on the assumption that the situation each year will be the same. However, if a senior will have a larger income one year and not be eligible for the GIS for a year as a result, it may make sense to delay a large RRSP withdrawal until that year. Things can get complex. Good luck helping your mother.

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  15. Thanks, the GIS table of rates is great.

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  16. Michael,

    When calculating the margin rate for RRIF withdrawal, did you consider the GIS earnings exemption, which has been increased from $500 to $3500? If Annie withdraw $7,380 from her RRIF account, $3,500 is exempted from GIS clawback.

    For some GIS receivers with smaller RRSP assets, they will be better off to withdraw only $3,500 each year and still receive the maximum GIS amount.

    Ben

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  17. Ben: My understanding is that the $3500 income exemption on the GIS clawback applies to earned income and that RRIF withdrawals don't count as earned income. However, I could be wrong. If you have a pointer to something definitive that makes it clear one way or the other, I'd like to see it.

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  18. Thanks Michael! You're right! I missed the keyword "earned". I revisited the 2008 Budget page http://www.budget.gc.ca/2008/plan/chap3c-eng.asp and had this confirmed.

    A question I'd like to double-check with you: From the http://www.servicecanada.gc.ca/eng/isp/oas/tabrates/tabmain.shtml page, you first select your "annual income range" then a detailed table is displayed. I assume this "annual income range" is net of the $3,500 exemption?

    Ben

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  19. Ben: Netting out the $3500 exemption if you have any earned income seems to make sense for these table look-ups, but I can't say that this is correct with any certainty.

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  20. An interesting discussion that has real relevance to a close family member who is one of those with little RRSP savings and will soon be 65. As well she lost her job some months ago and, unable to find work is now existing on CPP and EI. When she is 65 she should be eligible for GIS since her only income will be CPP. However if withdrawing her RRSPs after she is 65 (in November) she would forfeit the GIS at the 50% rate. We did have CRA confirm that the RRSP income is not considered "earned income" eligible for the $3500 exemption. So her best option appears to be to withdraw her RRSP money now, pay the tax and hope the GIS will help her in future. It is ironic that the GIS is calculated based on income only and assets are not considered.-- Fortunate for the person who sold his $500K house and can still collect a full GIS (less any interest on the $500K of course). Of course the wealthy shouldn't be collecting GIS as income support as that is not the group for whom it is intended, but I can imagine many adult children encouraging their (low income, high asset)parents to apply -- and thus saving their inheritance! Redeeming 15K worth of RRSPs has a much more negative effect for a much poorer senior.

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  21. @Gary: My guess is that the thinking is that wealthy people can't help but make some income (such as interest) on their assets, and will thus have to pay back the GIS. No doubt they would get the GIS in some years but not others.

    You may want to find an expert who can look at your family member's situation and determine whether it makes sense to collapse the RRSP. A true expert should be able to take the relevant information and give an answer in a few minutes while you sit there. The challenge is to find someone willing to do this for an hour's pay rather than selling some sort of full written plan for 10 hours pay.

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