RRIF withdrawal rules for retirees need to be updated

Retirees should beware of using the RRIF conversion age or the minimum withdrawal schedule as a guideline

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The government and the financial industry both take for granted that savers know what to do with their retirement accounts once they need to take withdrawals, but so much attention is focused on the need to save for retirement that the rules and strategies for decumulation tend to be overlooked.

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For example, registered retirement savings plans (RRSPs) are commonly converted to registered retirement income funds (RRIFs) by no later than age 71, with minimum withdrawals required thereafter that rising with age. Account holders have until Dec. 31 of the year they turn 71 to convert their account. Until 2007, the conversion age was the end of the year the RRSP annuitant turned 69.

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The minimum withdrawal for a 71-year-old who converts to a RRIF is 5.28 per cent in the following year when they turn 72. That rises to 6.58 per cent in the year they turn 80 and 8.08 per cent in the year they turn 85. The percentage is applied to the account value on Dec. 31 of the previous year. Withdrawals can be taken monthly, quarterly, annually or otherwise, as long as the total withdrawals are at least equal to the minimum required withdrawal for the account holder’s age. Withdrawals are taxable.

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There are no maximum withdrawals for a RRIF account. But if the funds are locked-in registered savings from a pension plan transfer, there may be an age-based maximum percentage based on the province or territory where the pension originated.

RRIFs are the most common conversion option for retirees, but an alternative is to purchase an annuity from an insurance company. This is essentially a monthly pension payment in exchange for an RRSP balance. Higher interest rates should lead to renewed interest in annuities.

The C.D. Howe Institute just released an e-brief, Strengthening Retirement Income Security: Fairer Tax Rules and More Options Needed, by Alexandre Laurin and George Turpie, who reference several proposals that have been put forth to modernize the RRIF withdrawal schedule.

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Amongst them: increase the age limit to 75 for mandatory RRIF conversion; lower the required withdrawals to reflect increased longevity; and potentially do away with minimum withdrawals altogether.

The United States has required minimum distributions that are lower than minimum RRIF withdrawals in Canada. For example, a 75-year-old U.S. retiree must withdraw at least 4.07 per cent of their account value compared to 5.67 per cent for a Canadian RRIF account holder.

The United Kingdom has completely done away with required withdrawals from defined-contribution pensions and self-invested personal pensions, which are like RRSPs. Up to one-quarter of a pension can also be withdrawn as a tax-free lump sum.

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I am generally in favour of more flexibility with retirement savings, but there are drawbacks to deferring and minimizing withdrawals. For one, it increases the likelihood that retirees work too long or spend too little in retirement. Despite my professional bias to make sure retirees do not outlive their money, my personal bias — largely influenced by my mother dying at age 66 — is that always saving for a rainy day is a risk in a different way.

Ignoring the potential to underspend your savings in retirement, deferring RRIF withdrawals may have another unintended consequence: it may result in overpaying lifetime income tax despite minimizing the tax early in retirement.

To use an extreme example, imagine a 55-year-old retiree living off their tax-free savings account (TFSA) withdrawals, which are completely tax free. If they have no other sources of income, they may pay no tax. If their RRSP continues to grow, those larger future taxable withdrawals could put them into a higher tax bracket. If a retiree is subject to the Old Age Security (OAS) clawback, they may pay up to 62 per cent in tax on their last dollar of RRIF withdrawals — their so-called marginal tax rate.

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By comparison, if they took modest RRSP withdrawals and conceded a bit of tax, they may be able to smooth out their income and tax payable over their lifetime. They may also be able to maintain their TFSA account and the associated tax-free income for longer.

If a retired couple defers their RRSP/RRIF withdrawals, and one spouse dies at a young age, the survivor will have future taxable withdrawals reported on one tax return instead of two. This will lead to a higher tax burden on those savings.

If both spouses die at a young age, or a single retiree dies young, more than half their RRSP/RRIF savings could be paid in income tax depending on the account balances and their other income sources in their year of death.

“As it is not possible to know exactly how long a retirement will last or how financial needs will evolve, some members may ‘underspend,’ leaving significant unused assets on death, or overspend and deplete their savings before death,” Laurin and Turpie said in their C.D. Howe e-brief.

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As a result, the decumulation of retirement savings requires a delicate balance. Any potential changes to RRIF withdrawal rules should be accompanied by education so that retirees can make informed decisions about their retirement savings.

Unfortunately, retirement advice is generally delivered by professionals who could have a conflict of interest or inadvertent bias. Financial advisers who are paid a percentage of assets may be motivated, even subconsciously, to advise retirees to underspend and maintain their retirement savings. They may also be more inclined to recommend a client start CPP and OAS early, even though most retirees would be better off deferring them to age 70.

Accountants, who may be biased towards short-term tax reduction, may encourage the deferral of RRIF withdrawals for those who could benefit from starting earlier, and may cause them to encourage RRSP contributions for savers whose income is low and should probably forgo contributions.

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Retirees should beware of using either the RRIF conversion age or the minimum withdrawal schedule as a guideline for their own retirement decumulation and spending decisions. They should engage in critical discussion with their investment adviser and accountant to take a long-term view of their financial planning as well as their preference to live rich or die rich.

The government should also consider revising retirement policies since what worked in the past may not work in the future.

Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever. He can be reached at jheath@objectivecfp.com.

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