As we know, the amount invested in an RRSP directly reduces your taxable income so you get a tax deduction today. The money invested then grows on a tax-deferred basis until it is withdrawn. When you withdraw money from the plan, it is treated as regular income and taxed for that year.
The common theory is that your annual income will be lower and you will pay less tax in retirement. But, as some retirees are finding out, this is not always the case.
Related: A sensible RRSP vs. TFSA comparison
Here are two examples for Ontario residents. Both have RRSPs worth $200,000 when they are converted to RRIFs.
Details are simplified and dollar amounts are constant for illustration purposes.
1. Company pension recipient
Pamela is a municipal city hall employee. She is earning $60,000 annually when she decides to retire at 65. Her company pension will pay 70% of her salary.
- Pension payment – $42,000
- Maximum CPP – $12,780
- Maximum OAS – $6,765
Total income $61,545
This amount puts her in the current Ontario and Federal mean tax rate of 20.94%
At 71 she converts her RRSP to a RRIF and withdraws the minimum required amount of $14,760 (7.38%) the following year.
Now her total taxable income is $76,305, which puts her into the next mean tax rate of 23.25%. She will pay approximately $1,700 more tax now than she originally deferred.
Related: Necessity Tetris: Retirement Edition
Pamela’s after tax income went from $48,654 to $58,563 after the RRIF withdrawal.
2. Low income retiree
Laura earns $38,000 as an office administrator for a small management company. She has no company pension plan, so when she retires at 65 she will receive government benefits only. Her low income makes her eligible for GIS payments.
- Average CPP – $7,327
- Maximum OAS – $6,765
- GIS – $9,173
Total income $23,265
Laura is in the 3.15% mean tax level. GIS is not included in taxable income.
At age 72, Laura also withdraws the minimum amount from her RRIF – $14,760 – which is added to her income. She is now at mean tax rate of 13.61% and pays an additional $3,500 in tax. On top of that the GIS payment is reduced 50 cents for every $1 she withdraws from her plan and she now receives only $1,893.
Laura’s after tax income went from $22,821 to $26,818 after the RRIF withdrawal.
As you can see from these illustrations, RRSP withdrawals are not as simple as we were led to believe.
In Part II we will explore ways to minimize the tax bite and allow you to keep more of what you have saved.