Wednesday, February 27, 2013

Handling RRSPs and RRIFs for Low-Income Seniors

I spent some time recently helping a low-income retired couple, the Wilsons, figure out what to do with their RRSPs now that they are on the verge of having to convert them into RRIFs. They know that because they collect the Guaranteed Income Supplement (GIS), the minimum RRIF withdrawals will reduce their GIS benefits. The question is whether there is anything they can do about this.

To protect their privacy, I’m not using the Wilsons’ real names and I won’t reveal their exact incomes or amount of savings. The fact that they collect GIS puts their income into a range, and I’ll reveal that their savings are shy of 6 figures.

I took a detailed look at how RRIF income affects the Wilsons’ finances, and one observation is that this is a complex undertaking. Low-income retirees don’t pay income tax, but they do receive a number of different types of benefits that are income-tested. This means that each dollar of RRIF income can reduce their benefits.

Not only is the GIS clawed back at either 50% or 75%, but GST/HST benefits can be reduced as well. The Wilsons live in Ontario and receive Ontario Trillium Benefits (OTB). Because they pay property taxes, they get the Ontario Senior Homeowners’ Property Tax Grant (OSHPTG). These benefits get reduced as income rises. There can be other types of income-tested benefits as well, but I’ve covered the 4 types that the Wilsons receive.

The default course for the Wilsons is to just take the minimum RRIF withdrawal amount each year. At their income level, the entire withdrawal amount causes their GIS to be clawed back at 50%. So, their net income (income tax return line 236) will rise only 50 cents for each dollar of RRIF income. Their OTB gets clawed back at 4% of this 50 cents, or another 2 cents. At the Wilsons’ income level, GST/HST benefits and the OSHPTG are not affected by minimum RRIF withdrawals. Accounting for all factors, the Wilsons only benefit by 48 cents for each dollar of RRIF income.

Another way to look at this is that only 48% of the Wilsons’ savings is really theirs if they follow the standard path. The remaining 52% will be lost due to reduced benefits. The question now is what can they do about this?

Surprisingly, the right answer may be to withdraw all of the RRSP/RRIF savings. I first looked at what would happen if the Wilsons were to withdraw the entire amount in 2013. This would trigger some income taxes and would completely eliminate their benefits for a year. The total tax bill plus benefits loss works out to 32% of their savings. This is a big blow for a couple who currently don’t pay any income taxes, but it is better than losing 52% with the standard RRIF minimum withdrawal path. Rescuing 20% of their savings is a big deal for the Wilsons.

Another scenario I looked at was to split the RRSP/RRIF withdrawals across 2013 and 2014. This reduced the total tax paid significantly, but creates 2 years of benefits reductions. In this scenario, the benefits don’t quite go to zero for 2 years, but they are almost zero. Totaling the income taxes and two years of benefit reductions works out to 33% of the Wilsons’ savings. So, this scenario is not quite as good as withdrawing the entire amount in 2013. Increasing the number of years of large RRSP/RRIF withdrawals just makes things worse.

As strange as it seems, the Wilsons’ best approach is to withdraw all their savings in 2013. A complication here is what they will do with the withdrawn money. The best answer is to put it in a TFSA. In the Wilsons’ case, once they pay their income taxes and hold back enough money to live on that makes up for the one year of lost benefits, the remaining savings just barely fit into their available TFSA room as of the beginning of 2014. They can even invest the remaining money in exactly the same investments that they had in the RRSP/RRIF.

So the Wilsons’ plan is to make a complete withdrawal near the end of 2013 (but not too close to the year-end that some kind of error would delay it until 2014). The brokerage will withhold 30% of the withdrawn amount for income taxes, but this will be more than the Wilsons will actually owe. Most of the remaining withdrawal will be made “in-kind” and placed in their TFSA. Part of this TFSA contribution will sit in a taxable account for a short time until the Wilsons have more TFSA room at the start of 2014. The Wilsons will take the small amount of the remaining withdrawal in cash. This cash combined with their 2013 tax refund will be used for living expenses to make up for the lost benefits from the middle of 2014 to the middle of 2015.

There are a couple of emotional issues with a complete withdrawal. One is that it just feels wrong to spend a working life building an RRSP and then just collapse it entirely in one shot. Another is that the TFSA account balance will be smaller than the RRSP/RRIF account balance. However, the entire TFSA account balance will belong to the Wilsons. Sticking with a RRIF means that 52% of the RRIF balance belongs to the government.

A caveat here is that I assumed the Wilsons will not earn any significant income in the future. If this is not the case, the entire analysis changes. Another possibility is that government rules for taxes and benefits may change in the future. But this seems like a reasonable chance for the Wilsons to take to save 20% of their money. This analysis was specific to the Wilson’s situation. Your mileage may vary.

13 comments:

  1. Yet another argument for simplifying our tax code and flat taxes. Our current tax system is insanely complicated and only gets more complicated as time goes on...

    ReplyDelete
    Replies
    1. @Greg: I agree that our tax code is very complex. And in this case, there is nobody with a financial incentive to help low-income seniors make good tax decisions because they don't have enough money to pay for advice. However, I can't see how a flat tax could be made to work. Suddenly raising taxes on many people is political dynamite.

      Delete
    2. Agreed. Simplifying taxes doesn't require moving to a flat tax.

      Delete
  2. I've seen this situation as well and I think it's unfortunate that low income people get sucked into buying RRSPs because they see all the marketing that financial institutions do and they don't realize that RRSPs are not good for them.

    And of course the mutual fund salespeople at the banks and elsewhere are just happy to sell some product - they don't want to mess with a sale by explaining a different tax strategy.

    ReplyDelete
    Replies
    1. @Mike: Even worse is failing to advise a switch to a TFSA prior to forced RRIF withdrawals. In this case, losing 32% of savings is painful, but sticking with the minimum RRIF withdrawals is like giving away 52% of savings.

      Delete
  3. Great details Michael.

    Your comment: "There are a couple of emotional issues with a complete withdrawal. One is that it just feels wrong to spend a working life building an RRSP and then just collapse it entirely in one shot."

    I see that with my parents right now. They have some RRSP savings, but not an entire nest egg, mainly because they are very fortunate to have some DB pensions. They have a bunch of debt I would never care to own and I'm advising them to start winding down their RRSP, slowly, to help with the debtload. If/when interest rates rise, they could be in trouble...

    The Wilsons move to top up that TFSA is an excellent one, assuming they have little to no debt.

    ReplyDelete
    Replies
    1. @Mark: Debt always complicates things. It sounds like your parents have some financial challenges. Fortunately, the Wilsons have no debt.

      Delete
  4. It would be interesting to know how much they contributed to their RRSPs, how much tax free income their contributions earned, and therefore what percentage of their contributions is now being lost to taxes and clawbacks. I sure hope that it isn't more than the % they were refunded on their taxes when they contributed to their RRSPs.....TFSAs are definitely better than RRSPs for this next generation to invest in if they have a low income.

    I'm also sorry this couple needs GIS. That means their retirement income is really small. I hope they are managing ok.

    ReplyDelete
    Replies
    1. @Bet Crooks: The percentage of their RRSP contributions and tax-free income being clawed back would come out to 52% over their lifetimes if they stay on their current path. You're right that TFSAs are much better for the Wilsons' case.

      You shouldn't feel sorry for the Wilsons. They are managing quite well even have enough to fly to see their grandchildren once in a while. It's amazing how little income you need if you're debt-free, have no job-related costs, and know how to avoid obvious wastes of money.

      Delete
    2. That's good to hear! I guess partly it depends whether you have anywhere to live. I know a person on GIS whose rent is making life pretty tight. But fortunately she too has found ways to live a good life even so.

      Delete
    3. @Bet Crooks: Good point. The Wilsons own their home outright. Their finances would be much worse otherwise.

      Delete
  5. I understand your wish to protect their identities, but the lack of figures makes this article really hard to understand.

    ReplyDelete
    Replies
    1. @Kevin: I get complaints on both sides. Some people want more numbers and others fewer. I can't add any more numbers in this case, so you'll have to treat this as a "concept" post -- know that low-income seniors may be best off to drain their RRSPs or RRIFs. Maybe I'll do a hypothetical post in the future with some concrete figures.

      Delete