29. RRSP, LIRA, TFSA.... Where do you withdraw from first?

Transcript:

Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.

Today we are continuing with my series about the retirement readiness checklist I have available on my website and today's topic is going to be discussing your plan for withdrawing from your savings accounts.

I'm going to start off by saying that there's a lot of factors that you need to consider when it comes to withdrawing from your retirement savings plans. And it's tough to go into enough detail in a podcast format without putting everybody to sleep and losing the details along the way. And so, as a result, I've actually filmed an on-demand video workshop that covers off this topic in much more detail, it is in very easy to digest chunks and you can go back and watch it whenever you want.  I'll have a link to the workshop below in the show notes. You can find that at courses.evanneufeld.com. Again, that's courses.evanneufeld.com. 

Getting right into the topic here. So we're going to talk about having a plan for withdrawing from your retirement savings. I had a comment on my Facebook post earlier this week saying “who needs a system for spending, it's easy” and I agree with this person. It’s absolutely correct that it is incredibly easy to spend money, which is why I believe that you need to do it correctly to make sure that you understand the implications of which plans you are withdrawing from. So when you're working, you have regular income coming from typically one source, your employer you'll get a paycheck from them.   Sometimes you might have investments that pay a little bit of something or you might get some interest or dividends here and there. But generally speaking, while you're working, you have one cheque to deal with, and it's pretty easy from there. But once you're retired, you have to create the paycheck. And typically you do that by withdrawing from the different places where you have investments and savings.

It's not so easy to know what you should do when you have all these different places where you can withdraw and how you should behave changes once your employment income stops and your other sources of income are taxed differently and they come in at different times and they're treated differently in regards to inflation and all this kind of stuff.  So let me just get right into it here. And let's talk about the different account types that you might have. 

The first ones that most people think of when they think of retirement income is an RRSP, registered retirement savings plan and that eventually converts to something called a RRIF, which is a registered retirement income fund.

Secondly, the next one is called a Locked in retirement account(LIRA) and generally speaking, you'd have one of these if you had a pension plan at a previous job and you quit and you transfer the money out. So you can still have the money, but it's no longer part of a pension because you left the employer.

So when it's in a LIRA and eventually you want to start taking money out of it, it converts over to something called a LIF, a life income fund.

Third, we have a non-registered or sometimes it's referred to as an OPEN account. Sometimes you might see this as even something called a cash account, which is extra confusing.But just think non-registered whereas the first two plans an RRSP and Lira, those would be called registered plans. Then there's a non-registered plan.

And then finally we have the TFSA, a tax-free savings account and if you've been listening to my podcast for long enough, you know, that I treat those like a tax-free retirement account.

So those are the main account types and I've podcasts and things like that going over all the details. And in my workshop, I go through a lot more specifics about each of those plan types and how they work. But moving on here a little bit,when it comes to your retirement income, You have to ask yourself, what is your ultimate goal? For most people, assuming that you've actually saved enough for yourself, most people are wanting to reduce their tax bill as much as possible. A second goal that you might have would be to spend as much as possible and you spend your last penny on the day you die, right on your death bed. Obviously this isn't super common, then the strategy would be quite a bit different for you and if you have a good handle on the day you're going to die, I'd like to speak to you because that kind of foresight is tough to find! So assuming that our goal is to reduce our tax bill throughout retirement and leave something for maybe our kids or grandkids or nieces and nephews or charity, something like that.  When we pass, we want to keep our tax bill as low as possible, so there's something leftover to give to the next generation. So when does a tax bill actually show up? Well, if we're talking about registered plans, again that's the RRSP and the LIRA typically, taxes when you withdraw from the plan. And so when you've converted those into income generating investments, or once you've retired and you need to start taking money out of those plans, every dollar that you take out of them is treated like taxable income to you.  Just like it would be in employment.

Then a non-registered account, when you earn interest or dividends or incur capital gains, that's when you pay taxes. So generally speaking, you can't choose when you take interest or dividends and so you'll get a tax slip most years that you receive those. Capital gains, for example, you would incur capital gains if you sold an investment to make a withdrawal, or if you decided to invest in something different, that's when capital gains would show up.

So if you make a withdrawal from investments in a non-registered account, there's often going to be a combination of return of capital. So that's the original money that you put in and the capital gain that is applicable to that investment that your withdrawing from.

Thirdly, a tax-free savings account. When does tax show up? Never. This one's super easy. Tax-free means tax-free so that's while you're alive, if you make a withdrawal, it doesn't matter. There's no tax there.

Now, one important thing to know here is that taxes are also applicable in the same way when you die. So with registered accounts, the entire balance that you would have in those plans, if you were to pass away is included in your income in that year if you can't pass it along to a spouse.

So if you're married and you have registered plans, generally speaking, those can be transferred to your spouse on a tax deferred basis. But if you don't have a spouse to transfer to, the total balance is included in your income in the year that you pass away. So you can assume that that can get a little bit crazy.

Secondly, capital gains are also applicable upon death. So even if you aren't choosing to liquidate those assets when you pass away, that would be a taxable disposition there. And so capital gains would be applicable in that case as well. Finally, the TFSA’s, they can be passed to a beneficiary without tax, again tax-free forever. So if you're alive or dead, TFSA’s remain tax-free.

So, if we're talking about tax efficiency here, a registered plan is the absolute worst. As far as once the money is in any of these plans, how is tax treated from there? Okay. So every dollar in a registered plan will eventually attract a tax bill. So when you take it out or when you die, it doesn't matter if you have capital gains, dividends, interest, it doesn't matter what it is. Every dollar is taxable and depending on how much income you have will determine your tax rate. So the more income you have, the more tax you pay and I've got a couple of episodes earlier on about understanding the tax system a little bit more, but generally speaking, the more income you have, the more tax you pay.

Let's use an example here. So if you make a withdrawal from a registered plan of say $40,000, you're going to pay tax on all 40,000. Yes, you might have credits and things like that, but it's all treated as taxable income. Now the next most tax efficient is the non-registered account and the reason for that is capital gains.

So capital gains is the most common way that people will see returns on their investments and in a non-registered account, you only pay tax on 50% of capital gains. So let's use the same example. If you make a withdrawal of $40,000. And say there's 10,000 of capital gains on that $40,000 when you sell, you're only going to pay tax on $5,000.

Again, that's 50% of $10,000. Okay, so if you're still with me, not the whole capital gain or the whole $40,000 is taxable. This is obviously hypothetical, and the amount of capital gain is unique to your investments in your situation, but growth in a non-registered account attracts 50% less tax than a registered account.

Finally, the TFSA, that king of tax efficiency. There's no tax on growth, withdrawals, capital gains, dividends, interest or death. Doesn't matter, no tax. You're getting the point. Okay.

So if we're thinking about where you should be withdrawing from in retirement first, to make sure that your lifetime tax bill is as low as possible. If you want to have the greatest benefit of paying less tax over your whole lifetime, why would you shoot yourself in the foot and withdraw from your TFSA first? A lot of conventional wisdom says well you want to defer taxes as long as possible and so spend everything else first and keep pushing all those registered plans out further and further and further, it just seems foolish to me, right? Because the more growth that happens in the least efficient places means you're compounding your tax problem. It's a head in the sand strategy to say that you can keep deferring and deferring and deferring, because the tax man's coming doesn't matter.

So the rule of thumb that I like to tell people is that deferring tax typically won't result in a lower tax bill. There are some situations where maybe it can work, but they'd be more unique than otherwise. So by spending the least tax efficient plans first, you'll be able to save the best for last. So start looking at your registered plans as the first place you make withdrawals from.Yes, you're going to pay taxes on it, but you're going to be spending that money and allowing your tax efficient assets to grow much more efficiently over the long-term. This is the simplest way to reduce your lifetime tax bill and it's simple because you're preventing the big tax bill from accumulating in the first place.

So if you begin with registered plan withdrawals, then non-registered and then TFSA, you should be in pretty good shape. This is a very quick and simple look at this strategy, but if you want to learn more, I have an on-demand video workshop that I mentioned at the beginning of the episode, it's called “Saving to spending”, and it covers this topic in much more detail. It's available on my website at courses.evanneufeld.com. And I've got a link below in the show notes as well, where you can find that. This is one of those strategies that very few people actually understand. It's highly impactful and as applicable to most people.

If most retirees are actually looking to reduce their lifetime tax bill, there's no silver bullets and it requires a little bit of planning and this amount of planning is totally doable for people. It's just figuring out which accounts to spend first and which ones to leave to the end. Hopefully this was helpful for you and if you want to learn more, again, feel free to check out that workshop that I mentioned before. 

Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor.  Mutual funds and ETFs are provided by Sterling Mutuals, Inc.