Watch out for RRSP and RRIF taxation

Watch out for RRSP and RRIF taxation

I get lots of reader emails and questions, and the volume of emails and questions that top the list are generally about RRSP and RRIF taxation.

Savvy DIY investors already know this but it’s worth reminding everyone:

RRSP withdrawals and RRIF withdrawals are both subject to taxation.

Surprise!

This is because an RRSP works best with long-term, steady contributions such that savings or investments inside this account grow – until you take money out of the account. Your taxable income will include any RRSP withdrawals for the year.

Withdrawals from a RRIF are fully taxable as income in the year withdrawn. When you withdraw more than the minimum withdrawal amount from your RRIF, you will also pay a withholding tax (which will be withheld by the financial institution and submitted to the government(s) on your behalf).

Needless to say, I think we all want to pay less tax while keeping more money/income for ourselves.

This makes it essential to know the ins-and-outs of RRSP and RRIF taxation.

Watch out for RRSP and RRIF taxation

In previous posts on my site, I’ve provided some general guidance on RRSPs, RRIFs, and much more including beneficiary considerations. I’ll link to that content at the end.

I’ve also shared what I intend to do when it comes to withdrawals from my/our RRSPs/RRIFs as well.

How and when to withdraw from RRSP and TFSA

But personal finance is personal is a constant refrain on this site for a reason – since your individual circumstances might dictate tax “hits” sooner or later related to your RRSP or RRIF account.

To share some objective takes on the RRSP and RRIF taxation subject, I’ve once again engaged respected CFP® Mark McGrath.

Mark McGrath holds Chartered Investment Manager (CIM®), CERTIFIED FINANCIAL PLANNER®, and Chartered Life Underwriter (CLU®) designations as a Wealth Advisor with Wellington-Altus Private Wealth in Squamish. Knowing my personal circumstances are likely different than yours, I figured Mark would be the perfect person to expand on my insights.

Mark McGrath, welcome back!

Mark, always a pleasure.

Mark, let’s remind folks about the tax implications of RRSP withdrawals, at any age. Meaning, for the most part, RRSP withdrawals will have withholding taxes applied. Can you explain how that happens in real life – how taxation is reconciled at income tax filing?

That’s correct Mark, and I know you’re planning ahead for semi-retirement!

RRSP withdrawals are taxable income, and tax will be withheld at the time of the withdrawal. The *withholding tax rate is based on the amount of the withdrawal. The amounts are:

• Up to $5,000: 10%
• $5,001 – $15,000: 20%
• Over $15,000: 30%

*Note, different rates for Quebec. Source: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/rrsps-related-plans/making-withdrawals/tax-rates-on-withdrawals.html

This isn’t a penalty, it’s a pre-payment of your taxes for the year, similar to tax withheld on employment income.

Say you withdraw $6,000 from your RRSP. You pay a 20% withholding tax, or $1,200, and receive $4,800 to your bank account.

When you file your taxes for that year, you’ll report $6,000 of income from the RRSP withdrawal, and $1,200 in taxes paid. If you’re in the 29.65% tax bracket, your total taxes owing on that withdrawal would be ($6,000 x 29.65%) = $1,779 – of which you’ve only paid $1,200. That means you’ll owe another $579 in taxes for the year.

That’s not necessarily true about Registered Retirement Income Funds, or RRIFs.

With a RRIF, you have a minimum withdrawal you must make each year based on either your age or your younger spouse’s age. That minimum payment does not require a withholding tax. It’s still taxable, but you have the choice not to have taxes withheld at source. If you take an amount above this minimum, then withholding tax will be applied to the excess, using the same thresholds we talked about above.

Perfect. A great primer. Let’s talk about the benefits of turning your RRSP into a RRIF, at age 65. Why is that age/date an important consideration? I get a few reader questions on that age-point.

Mark, I know you are aware, but all your readers should know while you can convert your RRSP to a RRIF at any age, 65 is important because from that point on, RRIF income is considered eligible pension income. And that gives you two opportunities:

• pension income splitting, and
• the pension income tax credit.

Pension income splitting allows you to split up to 50% of your RRIF income with your spouse, regardless of their age. That helps lower the overall family tax bill since you can both use up your lower tax brackets.

The pension income tax credit is a non-refundable credit on up to $2,000 of eligible pension income. This tax credit is based on the lowest tax bracket, which is 15% for the federal portion and 5.05% for the provincial portion in Ontario. That translates into a reduction in taxes owing of $401. Note the provincial amount varies by province.

Indeed. Let’s dive deeper, why your 60s or age 65 could be a good trigger for RRSP withdrawals or turning RRSP assets into a RRIF. I view RRSP assets as an estate planning liability. Let’s unpack that.

Mark, I hear you. It is a liability, since RRSPs are taxed – eventually.

Generally, the fair market value (FMV) of your RRSP/RRIF at your death becomes taxable income on your final tax return – with some exceptions which we will talk about a little later. That can be a significant amount and might even be taxed at the top tax bracket.

Having said that, you must factor in the tax refund you received when you made the contributions, as well as the tax-free compounding of your investments along the way.

Investors should think of their RRSPs as pre-tax money, unlike a TFSA.

Assume you pay tax at 50% for a simple example. If you earn $10,000, you have two options:

1. put $10,000 into an RRSP and pay no tax
2. put $5,000 into a TFSA after paying the tax bill.

Assuming you earn the same rate of return in both cases and assuming your tax rate at retirement is also 50%, then the after-tax outcome of both choices is identical.

We don’t usually think of it that way because we see the RRSP assets but haven’t accounted for the tax refund we received when we made the contribution.

Personally, I think RRSPs get a bad reputation because of this, and I think it’s undeserved. When you factor in income splitting and the tax deductions received, an RRSP can often come out ahead of a TFSA after tax.

But there’s no denying it – RRSPs and RRIFs can eventually come with a hefty tax bill.

Yup. Let’s talk about the future – death and taxes. What happens to the money in my RRSP/RRIF, if I pass away, generally speaking?

With some important exceptions, the fair market value of the RRSP/RRIF is taxed as income on your final tax return in the year of death. For example, if the balance of your RRSP or RRIF is $500,000 when you die, that’s $500,000 of income that is added to your tax return and taxed at your marginal rate.

Any income earned in the plan after your death will be taxable to your RRSP’s beneficiaries. If there are no beneficiaries, then that income is taxable to your estate.

Going further, what happens if I name my spouse/partner as my RRSP beneficiary?

In that case, the RRSP can be rolled over to your spouse or common-law partner on a tax-deferred basis. The amount can be transferred to their RRSP without tax and will be taxed in their hands on withdrawal.

The surviving spouse claims the fair market value of the RRSP on the date of death as income, but then receives an offsetting deduction for rolling it into their RRSP.

To qualify, the surviving spouse must make the transfer by December 31^st of the year following the year of death.

You are not required to do this, and there can be circumstances where rolling only part of the RRSP makes sense. For example, if the spouse has little income that year, then part of the RRSP can be included in their income, taking advantage of their lower tax brackets. They also have the option instead to purchase an annuity. In that case, taxes are paid on the annuity income received each year.

Ya, I recall the annuity part which is essentially a pension. Folks really don’t like annuities but I don’t know why?! I provided a great, detailed post below with Alexandra Macqueen: a fee-for-service financial planner, author and faculty member at the Schulich School of Business. (She has been a big advocate of pensionizing your nest egg at some point).

Here are ten questions and answers on annuities below.

Ten Questions on Annuities – Answered Here!

Mark, what happens to the money in my RRSP, if I pass away, and there is no last surviving spouse/partner or named beneficiary?

On the death of the last spouse, the RRSP is taxed as income, as above. The exception to this rule is if the beneficiary is a financially dependent child or grandchild. If they qualify because of mental or physical infirmity, they can roll the RRSP over to their own RRSP, or to an RDSP where they are the beneficiary. Note they would still have to abide by the $200,000 lifetime limit on RDSP plans.

If they are financially dependent but not due to a mental or physical infirmity, and they are younger than 18, then the RRSP assets can be transferred to a term-certain annuity. The annuity must pay out in full before they turn 18.

If none of the above applies, then the RRSPs will be taxed on your final tax return.

RRSP beneficiaries seem crucial to me, when it comes to estate planning. Any other considerations for RRSP beneficiaries or withdrawal strategies we should know about?

I’ve seen cases where RRSPs were left to non-qualifying beneficiaries, like independent, adult children. That might be okay, but can create a tax problem. Since they receive the full amount of the RRSP on death, with no taxes withheld, the estate needs cash to pay that tax bill. If there’s insufficient cash in the estate, CRA can go after the executor, or the beneficiaries, for the tax bill. In some cases, it might be better to name the estate as beneficiary to avoid this problem and ensure the estate has money to pay the tax bill.

Good guidance.

Mark, you might have gleaned from my questions that I also view RRIF assets as an estate liability. Meaning, depending on your income needs throughout retirement, it might not be wise to keep that account afloat with lots of assets “until the end”. Let’s unpack that too.

Possibly. It’s one of those questions that you’ll rarely know the answer to in advance. Because the returns on your investment portfolio are sheltered from tax in your RRSP and RRIF, they are quite tax-efficient. In fact, over a long enough time frame, an RRSP/RRIF can be more tax-efficient than a non-registered account – even if you’re in a higher tax bracket when you withdraw the money than you were in when you made the contribution! That breakeven point vs. the non-registered account is going to depend on the time horizon, type of investment income, and return on the investments. So like many answers in personal finance – it depends.

What happens to the money in my RRIF, if I pass away, generally speaking?

It’s generally the same as the RRSP. When you die, you are considered to have received an amount equal to the fair market value of the RRIF – unless your spouse is named as successor annuitant, which I’ll discuss below.

What happens if I name my spouse/partner as my RRIF beneficiary? i.e., is there a way to reduce the tax implications when transferring the RRIF assets to a surviving spouse/beneficiary? 

You can name your spouse as either a successor annuitant or a beneficiary. There’s an important difference – with a successor annuitant, the RRIF continues on in your spouse’s name. Any income from the date of death remains in the RRIF, and any payments out of the RRIF are taxable to the successor. But when named as the beneficiary, it’s like the RRSP. The amount is considered income to them, and they can receive an offsetting deduction for transferring it to their own RRSP or RRIF. But any increase in value between the date of death and the date of the transfer is taxable to them. For that reason, naming your spouse as the successor annuitant of your RRIF is often preferred.

Makes sense to me and we’re planning to do that years down the road assuming RRIF rules don’t change. What happens to the money in my RRIF, if I pass away, and there is no last surviving spouse/partner or named beneficiary? 

Then it’s treated much like the RRSP. If there is a qualifying survivor, namely a financially dependent child or grandchild, it may be possible to roll over the RRIF assets to their RRSP or RDSP. If there are no qualifying survivors, for example only independent, adult children – then the total amount will be taxed on your final tax return.

As a follow-up, does it make sense to keep lots of RRIF assets “until the end”? I’m not planning to since we don’t have kids.

Maybe, Mark!

But you won’t know the optimal outcome until it’s too late. While you benefit from the tax deferral on keeping the RRIF intact, you likely face a higher terminal tax bill. That can still be a better outcome than using a non-registered account since the aforementioned tax drag can create a worse outcome than leaving the money in the RRIF.

With that, you must also consider whether additional RRIF withdrawals will subject you to Old Age Security (OAS) claw back or other income tested benefits.

For my clients, we can test multiple scenarios including leaving the RRIF intact or making additional withdrawals up to certain limits. It’s not always apparent at first glance which path is best.

I think a lot of this decision comes down to what you might do with the additional money. If you just invest it in a non-registered account, it might make sense to leave it in the RRIF. But if you have other plans – like spending the money on experiences or gifting the money to your family – then that’s a noble use of the money, and the optimal tax scenario might be a secondary consideration.

Ya, I see taxation as a consideration but not the primary driver of our financial decisions. We plan to spend our RRSP/RRIF money over a few decades and leave any remaining TFSA money intact “until the end”. OK, any other considerations for RRIF beneficiaries or withdrawal strategies we should know about?

Similar to the RRSP, be careful naming beneficiaries without a thorough estate plan.

Agreed. As we wrap this post, Mark, what other worthy takeaways are worth demystifying when it comes to RRSP/RRIF taxation? Do you agree or disagree with the general notion that RRSPs/RRIFs are an estate liability?

I agree that it’s a liability, but it needs to be quantified.

First, you have to consider the tax refunds you received along the way, as well as the benefit of tax-free compounding of your RRSP/RRIF portfolio over potentially many years. Most Canadians will likely take advantage of income splitting on the RRIF withdrawals (i.e., starting at age 65), hopefully over many years. If you contributed at a high tax bracket and withdrew the majority of the RRIF at lower brackets over time, then even with a sizeable balance at death, you might have benefitted from significant tax reduction over your lifetime.

We tend to focus on that final tax bill, but when you consider these other facets, it still might be the optimal scenario.

But no one likes cutting a big cheque to CRA. I don’t think you will!

Ha, not in my plan for sure, Mark. Thanks for doing this.

Folks, first, a big thanks to Mark McGrath.

Second, a lot to digest here but I’ll offer a few simple takeaways for your further reading and potential RRSP and RRIF taxation planning, some thoughts from yours truly:

1. Whether you decide to make RRSP withdrawals or turn your own RRSP into a RRIF, know that RRSP and RRIF withdrawals will trigger taxation impacts. So, you can consider being “strategic” with your RRSP withdrawals (i.e., take out as much or as little as you wish) before age 65 to help mitigate taxation. See point #2.
2. Determining the timing and amount of your RRIF withdrawals is likely going to depend on your other income sources in retirement, your age, and your marital status as key drivers.

Consider the following:

2a. If/when you establish your RRIF, you can have your RRIF withdrawal based on the age of your spouse. So, if your spouse is younger than you by a few years, you can lock-in lower, minimum withdrawal payments that could reduce your taxable income.

2b. Like we highlighted above, RRIF income qualifies as eligible pension income for pension splitting. So, if you are age 65 or over, you can split 50% of your RRIF income with your lower-income spouse to reduce your combined, overall, tax bill. Smart!

2c. If you do decide to start splitting RRIF income, at age 65, or least taking your own RRIF income at age 65, then $2,000 withdrawn from your RRIF each year between the ages 65 to 71 will qualify for the pension income tax credit, and that triggers an annual 15% Federal tax credit on $2k (or $300) on your tax return. Small potatoes overall but take any meaningful tax credits when you can!

3. Smart RRSP and RRIF tax planning is important because if you withdraw funds from a spousal RRSP or spousal RRIF – any withdrawals in excess of the minimums could be attributed back to the contributing spouse. This applies up to amounts contributed in the current year and previous two calendar years.

Source: https://www.taxtips.ca/rrsp/spousal-rrsp-rrif.htm

4. Finally, if you don’t need all the RRIF income, or even some RRIF income every year, then consider contributing the cash withdrawn from your RRIF to your TFSA every year, up to your TFSA contribution limits. This way, you’ve moved tax inefficient money (tax-deferred money) from your RRIF to your TFSA to compound tax-free moving forward. The TFSA is an outstanding retirement account for longevity risk, tax-free income spending and/or estate planning “until the end”.

Let me know if you have additional questions for me, or the other Mark, happy to answer!

Thanks for your readership.

Mark S.

Related Reading:

I provided some beneficiary considerations for TFSAs, RRSPs, RRIFs and more accounts here. 

Beneficiaries for TFSAs, RRSPs, RRIFs and other key accounts

Mark McGrath and I collaborated on this post – essential reading if you have a corporation:

Taxation of investment income in a corporation

Along with my own preferred drawdown order, I highlighted a number of overlooked retirement income planning considerations here:

Overlooked retirement income and planning considerations

There are also dozens of Retirement stories and essays you can learn from there. You can also hire me on that page for my time and DIY services. 

Finally, why living off dividends in perpetuity is usually a mistake.

Disclosure and notes:

Mark McGrath is a Wealth Advisor with Wellington-Altus Private Wealth (WAPW).  The information contained herein is provided for informational purposes and should not be construed as financial, legal, tax or investment advice. Please consult a financial advisor and tax professional with respect to your personal financial situation and objectives. Please note that while current at the time of publication, tax rates are subject to change. WAPW is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. 

Mark Seed is a DIY investor and advocate for DIY investing in Canada. I share content on my site for general education and information purposes only – to help Canadians learn more, save more and grow more. Please review more disclaimers and related clauses here.