A Case Study in RRIF Strategy: When Less is More
The Dilemma:
Imagine you're Beth, concerned about your mother Susan's financial future. Susan, 80, is widowed, lives in a retirement home, and has a modest income. Her assets include a RRIF with $1.2 million, a TFSA with $300,000, and a taxable account from the sale of her family home with another $1.2 million. The investments are mostly individual Canadian dividend-paying stocks.
Beth's accountant raised a red flag about the size of Susan's RRIF, warning of potential large tax bills upon her death. This led Beth to instruct Susan's advisor to increase RRIF withdrawals beyond the minimum, seemingly a prudent move.
The Strategy:
The plan was to cover Susan's spending, top up her TFSA, and then invest the excess withdrawals in her taxable account. On the surface, it seemed logical: pay taxes now, potentially avoid larger taxes later.
The Unexpected Outcome:
However, the strategy had unintended consequences. The excess withdrawals resulted in two tax returns showing approximately $290,000 of taxable income annually, primarily from RRIF withdrawals, pension income, and taxable dividends.
The Tax Conundrum:
The higher tax rates on these withdrawals were significant. Around $40,000 was taxed at Ontario's top marginal rate of 53.53%, and another $75,000 at rates between 48% and 49%.
The Counterintuitive Solution:
This raises a crucial question: if the goal is to avoid high estate taxes, why not pay higher taxes now and move after-tax dollars into a taxable account? The answer lies in the power of RRIFs as tax shelters.
The RRIF Advantage:
RRSPs and RRIFs remain effective tax shelters, even in later life. Withdrawing excess money from a RRIF triggers potentially high marginal tax rates and moves it into a taxable account, where dividends, interest, and capital gains are taxed along the way, leading to a gradual erosion of wealth.
The Optimal Approach:
At Susan's age, the RRIF minimum withdrawal rate of 6.82% ($81,840) is sufficient to cover her spending, taxes, and TFSA contributions. There's no need for excess withdrawals, and keeping more capital inside the RRIF allows for compound growth without annual tax friction.
The Surprising Result:
Comparing the two strategies, Beth was surprised to learn that sticking to the minimum RRIF withdrawals leaves a larger balance at death, potentially leading to a higher tax bill. However, it also preserves more after-tax wealth overall.
The Takeaway:
This case study highlights the importance of considering the tax implications throughout retirement, not just at death. Pulling money from a RRIF at high marginal rates to avoid future taxes can shift the problem, often making it worse. The three Ds of smart tax planning - deduct, divide, and defer - offer valuable guidance.
The Conventional Wisdom:
Sometimes, the unconventional and boring approach is the right one. Taking the RRIF minimum withdrawal and leaving the rest untouched can be a more effective strategy.
