Deferral of RRSP income: A Great Tax Strategy . . .But

Posted: 17 Feb 2011 04:00 AM PST

When it comes to money and personal finance, this time of year gets people thinking about tax and RRSPs (Registered Retirement Savings Plan). When you buy your RRSPs, we often get focused on the tax deduction and forget the benefits of future tax deferral.

I just finished reading an article on Moneyville about how Registered Retirement Income Funds (RRIFs) work.

The article had a lot of good basic information, but I started shaking my head at one statement from David Birbeck, Retirement Product Strategist of RBC, near the end of the article.

"We advise clients to take out RRIF money last."

RRSPs and RRIFs defer tax

The whole point behind Mr. Birbeck's statement is RRSPs and RRIFs defer tax. Deferring tax is a common and meaningful strategy. In fact, it is one of the three D's of tax planning. Deferring of tax simply means instead of paying the tax now, you can pay it in the future — allowing you to use the government's money for your own benefit.

Aren't you supposed to spend your RRSPs in retirement?

Deferring RRSP and RRIF income is smart, especially in your working years. If you take money out of your RRSPs when you are working, you will probably pay more tax because you will be in a higher tax bracket.

When you retire, just remember the whole point of putting money into the RRSPs in the first place. You save money to enhance your retirement to make retirement the best years of your life. Despite this common goal, far too many people hit retirement and are reluctant to spend their RRSPs and RRIFs because of over generalized advice around the benefits of tax deferral.

When should you take money out of your RRSPs/RRIFs?

My advice has always been for retirees to come up with a withdrawal strategy for their RRSPs and RRIFs in retirement. Often this withdrawal strategy is to help retirees create more income so they can spend it. But for some, they don't need or want to spend the money, or they get so focused on tax deferral that they do not withdraw any money. Even if you do not need the money, it might make sense to develop a withdrawal strategy for other tax reasons.

Reasons why deferral of RRSP and RRIF income may not make sense

1. RRSP income can create clawbacks on income-tested programs. RRSP withdrawals are fully taxable and can cause higher incomes, which can lead to Old Age Security (OAS) clawback, and less Guaranteed Income Supplement (GIS). If you know your higher taxable income can create 'clawbacks', it can be advantageous to take money out of the RRSPs before you qualify for these programs.

2. Higher incomes in retirement. If you knew you would pay 32% tax on any RRSP withdrawals in the future, would you be willing to take that money out now at only 25% even if you did not need the money? In most cases, people retire with less income than while they were working. However, I've run across many examples where people might actually have more income in retirement. This can be more common with people who have defined benefit pensions and others who plan to work in retirement.

3. Deferral of lifestyle. Retirement is not just about money and tax. People who defer their RRSPs to age 71 are also deferring their lifestyle. Think about this . . . if you have not used your RRSPs by the time you turn 71, what makes you think you will need your money after 71? I see so many people deferring RRSPs to age 71 only to find they can't spend it later. They then take minimum income because they have to but don't even spend that money. And then they die with too much RRSPs.

4. Taxation of RRSPs at death. I've written extensively about why you do not want to die with too much RRSPs. The tax consequence can be too significant. You might wind up paying even more tax when you die than if you developed a withdrawal strategy while you were living.

Planning is personal

My guess is that RBC does not advise all clients as a general policy to take money out of RRSPs and RRIFs last. If they do, that's very wrong. This statement is too general and can be misleading and misguiding. Planning is personal.

All the theory in the world is useless unless you can apply it to yourself. Just because it made sense for someone to defer RRSP income into the future, does not mean you should, too. Good planning will make all the difference, so take this information and apply it to you.

Jim Yih is a financial speaker and fee only advisor. He is the man behind the RetireHappyBlog.

Dollar Matters: Taxing Questions

Posted: 16 Feb 2011 09:00 AM PST

There s A LOT going on with taxes right now in the world of personal finance. Indeed, everyone seems to be talking about taxes. So, here are a bunch of recent articles about taxes:

How to File Your First Tax Return

Wise Bread offers a look at how to file your first tax return. A helpful look at what you need to do when you are ready to file for the first time.

How Long Will it Take To Get Your Tax Refund?

PT Money provides a timetable for when you can expect your tax return. Hint: You’ll get it faster if you e-file and sign up for direct deposit.

Marriage or Divorce as a Tax Shelter

You really can use your relationship as a tax shelter. You just have to know how, and Free Money Finance will show you how it’s done.

How to “Cheat” on Your Taxes — Legally

Get Rich Slowly, with help from The IRS Hitman, offers you some great advice on how you can make deductions work in your favor.

Are Credit Card Rewards Taxable?

My Dollar Plan takes a look at credit card rewards, and helps you figure out what is taxable.

What To Do If You Are Mission Your Forms W2

Faithful With A Few can help you figure out what to do with your taxes if you are missing your W2 forms.

9 IRS Audit Flags You Must Avoid Like the Plague

Wealth Pilgrim helps you avoid a tax audit. Read about these red flags, and then do your best to avoid them.

Which is More Valuable: Tax Deduction or Tax Credit?

I wrote this post on Free From Broke. Just in case you were wondering, a tax credit is more valuable than a tax deduction.

Tax Refunds Are A Bad Thing

Boomer & Echo argues that you really don’t want a tax refund. Really. It’s better if you don’t end up with a tax refund.

Life Insurance Blog