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Planning Income Mixes for Tax-Astute Retirees

by Evelyn Jacks

Retirees can and should use the tax system to their advantage in structuring income to preserve capital. An important way to do this is to plan an income mix that is tax efficient.

Retirees face many tax obstacles when the income mix is wrong. Most middle-income Canadians are subject to clawbacks on tax preferences such as the age amount, or on social benefits like Old Age Security. They also suffer “time value of money” problems when they unnecessarily “pay forward” taxes on compounding annual interest returns earned outside registered accounts and, possibly, quarterly tax instalments.

Further, the “off-return” taxes – user fees – can often increase dramatically when income structure is not carefully planned and monitored. For example, per diem fees at nursing homes can spike dramatically when net income levels are too high, and public pharmacy care plan deductibles can wipe out assistance for expensive drugs like anti-cancer medication.

Therefore, tax-efficient retirement income planning is critical to the financial health of those 55 and older. As this group must withdraw taxable pension accumulations from both public and private sources at certain age levels (65 and 70), reinvestments of disposable income must include a careful selection of tax-efficient investments.

When it comes to mutual funds, income taxes do matter and, in fact, tax efficiency is material in getting the desired results in retirement wealth planning. There are generally two ways a mutual fund investor’s returns are directly affected by taxes when assets are held outside registered plans: on annual taxable distributions throughout the investment holding period and on liquidation of the taxable investments. It is important to select funds with high after-tax efficiencies to avoid pushing income from public and private pension sources into clawback or provincial surtax zones.

So, where to begin in structuring the optimum tax-efficient income mix? As every professional knows, this is very difficult. Not only do tax laws, brackets, rates and surtaxes change constantly, but for most taxpayers, disposable income varies with life-cycle changes and can therefore be unique. A plan should take into account marital status, income level, income source, province of residence and the opportunity for inter-spousal or inter-family income splitting on an annual basis. Then short and long-term investment income sources should be carefully analyzed in conjunction with available tax preferences, income-splitting and income deferral options. This is essentially a two-step process:

Step 1. Itemize Current Income Sources. Determine on a worst-case scenario basis the taxpayer’s cash flow requirements on a month-over-month basis. Then determine the marginal tax rates and quarterly instalments required to arrive at your desired results now and in the future, taking into account tax deferral and income-splitting opportunities. Actual Marginal Tax Rates (MTRs) may rise at certain income levels when federal clawbacks and provincial surtaxes kick in. In some cases, income source can further skew MTRs.

For example, John is married to Mary, who has no taxable income and few RRSP accumulations, which will cause an income-splitting problem in retirement. The couple wishes to plan for maximum tax efficiencies by equalizing RRSP deposits, which they can do by making spousal RRSP contributions, given John’s available RRSP contribution room. However, they also wish to immediately melt down John’s RRSPs and make tax-efficient investments over their remaining lifespans. How can this be approached? His income mix follows below.

Step 2. Defer Taxable Income Sources. Things change after age 65. Canada Pension Plan benefits must begin and Old Age Security is received, thereby raising taxable income and exposure to surtaxes in some provinces. Many Canadians also begin to make withdrawals from their RRSPs; usually in the hands of the lower income earner first. Age 65 also brings new credits in the form of age amounts, but also clawbacks as explained above. In our example, John has lost his wife to cancer by the time his public pension begins, and now files as a single taxpayer with no further income-splitting opportunities. Cash flow needs are reduced, but tax burdens increase.

John finds that due to his income level and his single status, he is subject to an additional tax burden – an OAS clawback of just under $2,000 per year. One way to eliminate the clawback is to stop generating taxable investment income entirely by choosing equity-based investments that minimize distributions and defer the tax until deemed or actual disposition later in life. This is a good strategy here, since John doesn’t need the extra cash.

Assume the same income structures in the prior example, but no RRSP deduction. By eliminating the $15,000 in taxable capital gains, he brings his income under the clawback zone. Tax savings of over $6,400 help shore up John’s current cash flow, while he defers taxes on his increasing equity portfolio to the future.

The moral? Tax-efficient investment product choices can significantly reduce taxes in the present, thereby increasing cash flow, while preserving capital and maximizing real returns on investments over the long term.

Evelyn Jacks is the author of 30 best-selling books on the subject of personal income taxation, and the President of Knowledge Bureau, Inc., Canada’s leading professional education publisher in the tax and financial services industry, specializing in delivering courseware and information services to knowledge-based practices. For more information call toll free 1-866-953-4769 or visit www.knowledgebureau.com.

This article is written to be of a general nature and neither the author, her company, employees, subcontractors or others associated with The Knowledge Bureau can take responsibility for any results, positive or negative, taken by any persons. While the author received a fee to write this article, she is not in the business of providing advice on investment products and is not registered and licensed to do so, nor does the author have any compensatory relationship, or beneficial ownership regarding the sale of investment products discussed herein


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