Thursday, May 24, 2012

Is the Tax System Stacked Against Retirees?

Retirees face mandatory RRIF withdrawals, clawbacks, and increased clawbacks due to dividend gross-ups. Many retirees feel that the tax system is stacked against them, including Gordon Pape. Whether this is true or not comes down to expectations.

In Canada, we have a number of programs designed to help subsets of the population financially. The favoured groups tend to be those with low incomes, children, and retirees. With OAS, GIS, and the age credit, it’s hard to argue that retirees have it worse than the typical working person under the age of 65. The only meaningful debate is whether retirees are favoured by an appropriate amount or whether they should be favoured more or less.

In his book Retirement’s Harsh New Realities, Gordon Pape makes a number of points to justify his assertion that the tax system is stacked against retirees. Let’s look at each one in turn.

Taxes on RRIF Withdrawals

Many retirees who saved diligently in their RRSPs for years are unhappy about having to pay taxes on their savings when forced to make RRIF withdrawals. I think the problem is that the tax breaks they received over the years are long forgotten and they come to think of their RRSP and RRIF balances as completely their own money.

The best way to think of your RRSP savings is as partly belonging to the government. If your marginal tax rate in retirement will be 30%, then the savings in your RRSP or RRIF is only 70% yours. Your part and the government’s part grow together, and when you make a withdrawal, the government gets their cut. Few people like paying taxes, but RRSPs are a great deal even when you have to pay taxes on withdrawals.

Mandatory RRIF Withdrawal Amounts

Wealthier retirees are unhappy about how much they are forced to withdraw from their RRIF each year. They complain that they can’t earn enough income to make the withdrawal and must dip into principal.

The RRSP/RRIF system was not designed to allow retirees to maintain their principal indefinitely. People are supposed to draw down their RRIFs as they age. Further, you don’t have to spend the money that you withdraw; a great strategy is to save the amount you don’t need right away in a TFSA. You are required to pay your taxes, but you don’t have to spend your principal.

OAS Clawback

Retirees with high enough incomes get hit with a 15% increase in their marginal tax rate in the form of an OAS clawback. Whether this feels like a hardship comes down to expectations. If you believe you are entitled to this money no matter your income level, then the clawback is maddening. However, we’re not talking about an extra tax on retirees; this is really a question of whether you get a benefit that younger Canadians don’t get. It’s possible to have a discussion about whether retirees should keep more of this benefit, but it’s hardly a case of retirees being singled out unfairly for higher taxes.

Dividend Tax Credit

The taxation of dividends can be confusing. As Pape points out, companies must pay taxes on their earnings before they pay dividends. So, the companies started with a larger sum before giving you your dividend payment. For your taxes, you are treated as though you received the larger sum, and then you’re given credit for the taxes the company paid. The amount you keep in the end is roughly the same as if you received the larger sum and paid regular taxes on it.  (Update: this amount is not exactly the same as I showed in a later post.  See here.)

This last part is worth repeating. The amount you keep after taxes is roughly the same as if you received the larger amount and then paid taxes at your marginal tax rate. Using Pape’s example, if you received $100, and this gets grossed-up to $138, the amount you keep of your $100 is the amount you would have kept if you had earned $138 of regular income.

Pape refers to the extra amount that you never really receive as a “phantom income.” He doesn’t like the way it increases clawbacks and affects other income tested benefits. I say you can’t expect to get credit for the taxes the company paid without using the grossed-up amount as income.

Dividends Paid to Registered Accounts

Pape makes a very good point about dividends earned in registered accounts (RRSP, RRIF, TFSA, etc.). Even though your investments are supposed to grow tax-free, you never get back the taxes paid by the company that gives you dividends. This is an inconsistency in the way that dividends are handled. Of course, this hits all people with registered accounts, not just retirees.

Capital Gains

Pape makes another good point that when you offset capital gains against past capital losses, you still get hit with clawbacks. I don’t see why your taxes owing should be different if you offset capital gains with this year’s capital losses versus last year’s capital losses.


I don’t believe that the tax system is stacked against retirees. In fact, they are favoured over typical taxpayers. I think it makes sense to favour retirees somewhat and we can discuss exactly how much they should be favoured, but this discussion won’t get anywhere if we start from the premise that retirees are being treated unfairly.


  1. Yes, good points. It always bugs me when people feel entitled when they should feel favored.

  2. The idea that the tax system favours younger working people over retirees is impossible to justify. You've a done a great job in exposing the flaws in Pape's arguments, almost all of which are based on the assumption that registered accounts were supposed to allow people to avoid taxes forever, rather than simply defer them.

    I would add another argument. Retirees are allowed to split pension income between spouses to reduce tax, while young families who choose to have one parent stay home to raise kids cannot do this. This costs young families thousands of dollars (sometimes tens of thousands) during a period when they are most cash-strapped. This makes no sense, and it's simply come about because the seniors' lobby is so powerful.

    I think it's fair to say that, in general, people only feel the tax system is fair when other people are paying more than they are.

  3. I think people just don't like "giving something up". Having mandatory RRIF payments makes perfect sense, but some retirees see the taxes being paid and think they are being ripped off. If you are writing a book geared towards retirees, it makes sense to cater to their feelings and use words like "forced withdrawals" rather than trying to explain the logic behind those withdrawals.

    As for OAS, the idea that the government gives out money for free (to combat poverty in the elderly) and only starts clawing back at around $65k is ridiculous. But not as ridiculous as people who complain about it (like my parents). :)

  4. @Greg: It's not clear to me whether these sorts of arguments are just a way to get more or whether they really see the glass as half empty.

    @Dan: Thanks. I definitely would have benefited from income splitting over the years. It will be interesting to see what happens when the echo generation develops enough political savvy to butt heads with the seniors lobby.

    @Mike: I have to agree that this part of the book was dangerously close to pandering. It sounds like you have some lively discussions with your parents :-)

  5. I am nearing retirement but I have always thought if you whine about having to pay to much tax you are likely making more than enough money.

    I have always followed Gordon's articles etc. but we all have to pay our fare share in the end.

  6. It could quite a risky strategy to rely on the government. Particularly retirees are vulnerable.
    They can not fight and the investments are already made. But the system is very complex to understand, indeed.

  7. I would like to add a couple of other benefits seniors get in addition to Potato's pension splitting.

    Retirees may get to claim a pension amount on their tax return.

    In addition, for seniors in Ontario, there is a more favourable calculation in determining refundable provincial credits based on age. I'm not sure why an older person's rent or property tax paid is worth more than a younger person's.

  8. re "The amount you keep in the end is the same as if you received the larger sum and paid regular taxes on it. " Using calculator 2012 rates, if you plug in $100k div income, for Ontario, tax is $10,216 and you have $89,784 left. Plug in $138k ordinary income to pay regular taxes, the tax is $43,576 and you have $94,424 left. I side with Pape on this one. It's phantom income but it isn't phantom tax.

  9. @CanadianInvestor: Your comment prompted me to look at this a little more closely. My explanation showing that you end up keeping the same amount of money was true in the past, but has become less true in recent years. Based on what I've figured out so far, the gross-up seems to be about one-fifth or one-sixth phantom income. I hope to get a picture of what has happened over the years and explain all this sometime next week.