Over the RRSP season I had the same conversation with both my father and father in law about RRSP withdrawals. It was over which account they should tap first, their RRSP or non-registered (everyone agreed to leave TFSA until they end and to max it out forever.)
I understood that non-registered accounts should be used up first and then RRSP so that you pay less in investment taxes over time. They think they should draw out RRSP money first or even draw extra money they don’t need immediately and invest it in non-registered account so they pay less income tax over time. I tried to explain that they would have more money if they waited, but both were concerned about the 50% income tax their estate/heirs would have to pay when they died.
After some back of the envelope calculations I think we are both right. I think they would have more money for themselves to use if they did RRSP last, but they could leave a larger inheritance if they took out extra withdrawals and invested it in a non-registered account.
So, my conclusion to them was that if they wanted to make the most out of their money for their own use then leave it in the RRSP, but if they plan to leave an inheritance then they can take extra out earlier.
Does this make sense?
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I’ve thought a lot about this type of question, and I don’t claim to have a definitive answer that covers all situations. I’m not even completely sure about my own situation yet.
In all the simulations I’ve done, going with the order non-registered, RRSP/RRIF, and finally TFSA has been either optimal or not too far off optimal. But I don’t claim to have looked at all possible financial situations people find themselves in during retirement.
There are so many variables involved, including the amounts you have in each type of account, other income you have, your year-to-year cash flow needs, and whether you are married. Other important factors that you can’t know are how long you and your spouse will live and what future changes the government will make to the tax system.
A change that seems likely at some point is to take into account TFSAs when giving out government benefits. I don’t think Canadians would be too pleased to see people with massive TFSAs collect GIS and other government money intended for low-income seniors.
A strategy I’ve read in a few places is to “top up” your current tax bracket. For example, in Ontario, the marginal tax rate on income below $42,201 is 20.05%. If your income is a little below this level, this strategy would have you withdraw enough from your RRSP/RRIF to top up this bracket. If you’re going to withdraw early from your RRSP/RRIF, then this makes some sense, but it doesn’t answer the question of whether you should be making such withdrawals early at all.
The father and father-in-law in P.H.’s question both focus on the large tax bill from their RRSP/RRIFs when they die. This is understandable, but may not give the correct conclusion. It’s often the case that you can withdraw RRSP/RRIF funds at a lower tax rate today than you’ll pay later on with a huge withdrawal at death.
But comparing tax rates isn’t the only thing you should consider. There is value in deferring taxes on investment gains as long as possible. Let’s consider an example to illustrate this point.
John is 65 and is currently in a 30% marginal tax bracket. He is considering withdrawing $5000 from his RRSP, even though he doesn’t need the money today. His TFSA contribution room is fully used, and so the $3500 remaining after tax would be invested in a non-registered account.
Suppose that John will live to age 90 and earn pre-tax investment returns of 7% per year. If the money stayed in his RRSP, it would grow to $27,137. Assuming John lives in Ontario and would be pushed into the top marginal rate at death, his heirs would get $12,610 resulting from the original $5000.
In the non-registered account option, suppose that yearly taxes would reduce the growth rate to about 6% per year. Further, he would pay capital gains taxes at death. The final amount going to John’s heirs works out to $11,938. In this example, John was slightly better off leaving the money in the RRSP.
In reality, the calculation would be more complex than this because a higher RRSP balance would actually lead to larger RRIF withdrawals each year. So, the $5000 would not actually stay in the account until John dies. Also, if John had any TFSA room available to hold part of an RRSP withdrawal, the comparison changes.
As for P.H.’s split conclusion about one strategy being better for the retiree and the other better for the heirs, I suspect this just because heirs benefit when retirees spend less. A true comparison comes when we hold retiree spending constant. Keep in mind that forced RRIF withdrawals do not have to be spent; they can be saved in either a TFSA or non-registered account. So, spending the RRSP/RRIF last doesn’t mean the higher forced RRIF withdrawals must be spent.
This whole area can get quite complex. For myself, I’m going with the idea that I don’t have to get the best answer, just a good one. My core plan is to spend non-registered money first, RRSPs second, and TFSAs last unless I get new information. However, I can see the logic of making early RRSP withdrawals if I can get the money out close to tax-free in a year where my income is very low, particularly if I have TFSA room to hold some of the withdrawal.