Tuesday, February 16, 2021

Which Accounts Should I Spend from First in Retirement?

For those of us retiring without employer pensions, it’s a challenge to find the best way to spend the savings in our various accounts, a process called decumulation.  Most of us have RRSPs/RRIFs (or other tax-deferred accounts) and TFSAs.  Some of us also have taxable (non-registered) accounts.  Even after we decide how much we can safely spend each year, it’s not obvious which accounts we should spend from first.  Here I describe how I spend from my accounts.  It may or may not work well for people whose financial circumstances differ from mine.

While working, our spending is usually closely linked to the income we declare on our taxes.  If we start with declared income and subtract taxes and savings, the rest is what we spent.  In retirement, it often doesn’t work this way.  If we spend from TFSAs or from taxable accounts, our spending can exceed the income we declare on our taxes.  This gives us some control over our reported income even when we’ve already decided how much we’re going to spend for the year.

As a general rule, deferring taxes is a good idea.  So, we might think that spending from taxable accounts and TFSAs first and RRSPs/RRIFs last would make sense.  But I didn’t find this to be true in my case.

My Decumulation Approach

To begin with, my simulations indicate that I should keep transferring assets from my taxable accounts to my TFSAs each year, and delay spending any TFSA money until the taxable accounts are gone.  Even then, it makes sense for me to reserve part or possibly all of my TFSAs in case I need to make large expenditures.  If I ever had to dip into an RRSP/RRIF to buy a car, help a family member, or pay for a medical emergency, the spike in the income I’d have to report on my taxes that year would be expensive due to Canada’s graduated rate tax system.

So, now it would seem that the correct spending order is taxable accounts, then RRSPs/RRIFs, and finally TFSAs.  However, if I do this starting today, I’d be declaring a low income consisting of just the interest, dividends, and capital gains from my taxable assets.  My simulations show that I’m better off spending from my RRSPs to top up my income to fully use the low tax rate brackets.  This is a trade-off between giving up some tax deferral to make a lightly-taxed RRSP withdrawal today versus a more heavily-taxed withdrawal in a future year.

So, each year early in December, I estimate my income and my wife’s income from all sources, and then take out enough from our RRSPs to take both of our incomes to the top of the second tax bracket.  I live in Ontario, and for 2021 this second bracket ends at an income of $49,020.  Others may find that staying within the first bracket or moving into the third bracket is better, depending on how much money they have saved.  The bulk of our spending today is from taxable assets, but with this topping up of tax brackets, some of it is from RRSPs.

As we get closer to our first forced RRIF withdrawals when we’re 72, it will become clearer whether the total income from CPP, OAS, and RRIF withdrawals (and possibly annuities if we buy any) will drive us into high tax brackets and possibly OAS clawbacks.  If it becomes clear that this won’t be a problem, then we’ll just continue as we have been from now until we’re 72.  If it looks like we’d be paying high taxes due to big RRIF withdrawals after we’re 72, we would start drawing larger amounts from our RRSPs/RRIFs in the years leading up to age 72.  This would have an income smoothing effect designed  to increase our total after-tax spending.

Depending on how large our TFSAs get, sometime after the taxable assets are gone we may start spending some of our TFSA assets each year to reduce the amount of RRIF income we need to draw.  Whether this makes sense will become clearer in our 70s.

This may seem like a lot to worry about, but fortunately, this is a very slow-moving problem.  We really only need to think about these issues once per year.  And likely, small course changes determined by portfolio returns and tax law changes will only be necessary every 5 or 10 years.

Feedback is welcome.  I don’t claim to have the perfect plan, and I certainly can’t say my approach will work well for others.  But I do think it will work well enough for me.

19 comments:

  1. Hi Michael,
    I find the same thing for my wife and I - drawing down some RSP money each year will save us tax in the long run. Can you tell us how you do your simulations (I have a fairly complex spreadsheet). Perhaps you could do a column (or 2 or 3 or 5) on your simulation model.

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    1. Hi Joe,

      I've done these simulations in C++. I think it would be possible to put them in a spreadsheet but it would be quite large. The main problem is that the code to decide how much to spend makes iterations on each year to hit a target after-tax spending, and then an entire retirement has to be iterated to hit the target asset level at the end of retirement. And all this gets iterated annually in the face of returns that didn't exactly meet the assumed returns when choosing the spending level. And we repeat this across a range of decumulation strategies. This isn't too difficult in software, but spreadsheets have a hard time with all this iteration.

      I haven't written much about all this yet because I'm not sure I have good enough answers across a range of account balances in RRSPs/RRIFs, TFSAs, and taxable accounts, not to mention other excitement like pensions, inheritances, and spending shocks. It's difficult to decide what range of investment returns to consider, and it's difficult to decide what range of decumulation strategies to consider.

      Another complication is that I'm satisfied I've got a good-enough answer for myself, and this reduces my drive to keep working on the problem. But I'll give it some thought.

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  2. Morning Michael! Great article. I've come to this conclusion as well that I'll withdrawal primarily from our registered accounts but use our non-registered and maybe TFSA depending on our income needs and tax brackets. The goal will be to try and minimize taxes in retirement and maximize any estate we might have.

    I'm still in the process of sorting our how much we spend each year in our retirement. I'm hoping it goes down! My wife and I are both semi-retired (we will be 62 this year) and we have a 17 year old daughter - yes we are old parents. I started withdrawals from my registered accounts last year and this year will be the first year where I will try and optimize withdrawals based on our tax brackets and expenses.

    I've just started using this tool that I find works really well to simulate a variety of financial plans and has an option to optimize withdrawals.

    https://www.moneyreadyapp.ca/

    Love to get your views and happy to share my findings as I iterate through this process.

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    1. Hi Joel,

      Glad you enjoyed my article. It sounds like your situation differs from mine somewhat. For the next several years, I'll be spending primarily from my taxable (non-registered) accounts rather than my registered (RRSP) accounts. Another difference is that I'm not trying to maximize the size of estate I leave. I'm going for the highest spending rate that's safe and plan to give away some of this annual spending to family while I'm still alive. I have no desires for my annual spending to decline as I age, but this could easily happen if I lose the desire to travel. Perhaps the differences between us have to do with the fact that my children are older than your daughter.

      I haven't tried the money ready app, so I can't comment on it.

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    2. We don't really have that much saved in our non-registered accounts. By far most of our assets are in registered accounts, so part of the reason we are starting with registered is level-out the withdrawals over a longer period of time. Hopefully, we will be able to continue to grow our TFSAs via withdrawals from our RRSPs depending on our expenses.

      I like your idea of giving away some of the annual spending to family while you are still alive!

      We have both a primary residence and a cottage. At some point we may decide to consolidate into one property probably in cottage country sometime in the future.

      Love reading your posts!

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  3. Do you think it could ever make sense to withdraw all or most of your RRSP in a single year to avoid future OAS clawbacks? The disadvantages would be that much of this amount is likely to be taxed at the highest marginal rate, there would be a loss of tax-deferred growth in the RRSP, and investment income from the withdrawn amount would be taxable. But I'm wondering if it's possible in some scenarios for the avoidance of the OAS clawback in subsequent years to outweigh these disadvantages?

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    1. Anonymous,

      I have a feeling the right amount to withdraw from an RRSP/RRIF in a single year is much less than "all or most", but the truth would be in the numbers. Keep in mind that the increase in marginal tax rate of OAS clawbacks is not the full 15% because the amount clawed back gets deducted from your income. So, if you're at a 40% marginal tax rate, the OAS clawback would jump it to 40% + 15%*(1-40%) = 49%. Making too big a RRIF withdrawal could easily add more than 9% to your tax rate. Further, when we're talking about RRSP withdrawals many years before forced RRIF withdrawals begin, you're also losing the value of deferring taxes.

      Answering questions like this accurately is tricky, and requires crunching numbers in an accurate model.

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  4. There is another reason to withdraw RSPs or RIFs early (which results in premature taxation). If both you and your spouse happen to die young (heaven forbid), having a large pool of registered funds can result in a huge tax hit for the estate as it all must be included on your final return. It becomes even worse if the last to die spouse passes late in the tax year. In that case it all gets taxed at the marginal rate. So the advice here is don't die young.

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    1. Hi Garth,

      What you say is true but I tend to give such concerns low weight. Dying young concerns me much more than taxes. I care about my heirs, but why is it so bad that my heirs get less money if I die young? After all, if I live a long life, they'll get no inheritance for decades.

      That said, this is a nice-to-have added benefit for the early RRSP withdrawal plan that minimizes taxes over a long life.

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    2. Hi Garth,

      Thinking more about your comment, perhaps this is a good point to mention to those who fixate on what happens to their estate if they die young. I think it makes more sense to worry about what happens if you live long, but if this point helps people make sensible decumulation plans, then I'm all for it.

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    3. Combine that with their utter contempt of paying taxes and you might have a winning argument for them.

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  5. Thanks for this information. In my case, at 66 and my wife 63, we have combined defined pension income of 105k so we will always be in the tax bracket above 49K. Thus, I am turning my RRSPs into RRIFs and already making withdrawals (then pension splitting this amount) with the goal to empty my RRSPs by 71, then taking CPP and OAS. Will do the same with my wife's RRSP. With TFSA contributions maxed out, the enviable challenge I have now is how to invest my non registered funds in the best tax advantaged way. Need to research this aspect.

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    1. Unknown,

      Assuming your RRSP/RRIF withdrawals are less than or equal to your future CPP and OAS payments, this sounds like a sensible plan.

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  6. Hi, a spreadsheet that I found useful and still use every year is
    http://pabroon.blogspot.com/2015/05/retirement-planning-and-forecasting-20.html

    I don’t think it is supported anymore, since the last version was in 2017. However if you update the tax-tables it is still relevant (even relevant with old taxtables). The one thing that would make it more useful is if one can estimate different returns and capital gains/ dividends for each account type.

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    1. Hi Tom,

      I took a quick look. I don't remember seeing this spreadsheet before, but it looks interesting.

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    2. Hi, there is also a blogpost that looks at the withdrawal question: http://pabroon.blogspot.com/2015/08/financial-studies-1-rrsp-withdrawal.html

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    3. Hi Tom,

      It's clear that this blogger considers mostly the same issues I've been wrestling with. A couple of things I've done differently in my software are that I've included asset location optimization, and I've allowed for available past capital losses. However, his spreadsheet is available to anyone who wants to use it, and my software is in no state for anyone else to try to use.

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  7. Michael, that is similar to what I have in mind for my wife and me. One complication is that I was contributing to a Spousal RRSP and we have to hold off withdrawing from that for 3 years from my last contribution because of attribution rules by CRA.

    Methinks you might be missing a tax-saving opportunity by only withdrawing from a RRSP. There is a Pension Income Tax Credit leading to a non-refundable tax credit for those over 65. The credit applies to up to $2k of "Pension" income which gives a 20.5% tax credit in Ontario, so $410 tax savings. My understanding is that RRSP withdrawals do not count as Pension Income, so transferring $12k to a RRIF and withdrawing $2k per year from 65 to 71 would entitle you to the credit.

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    1. Hi Bob,

      I contributed to a spousal RRSP as well. I've been retired long enough that the 3 years has run out now, but this could be a complication for others.

      That's a good point about the pension income credit. My wife and I still have several years before we're 65 so we haven't worried about it yet. However, we definitely want to have at least one small RRIF each by the time we're 65 to make sure we use this credit.

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