When you can control the amount f your income, when is the best time to let it become taxable? This question comes up fairly frequently with people who are drawing income at the minimum rate from a RRIF.
If you take minimums and die, there will be a large tax bill for the estate. That is not a serious problem because the funds will be there to pay the bill. The question of optimizing is not so easy. Should you draw income no even though you don’t need it? You will pay tax now instead of in the distant future, but likely at a lower rate.
First, the variables.
Suppose John is 73 and Mary is 65. Each is in good health, and each has a strong family history for long life. There are no estate issues on the first death.
John has a RRIF with $400,000 in it. and is taking the minimum income based on Mary’s age – 4%, Mary has $200,000 in an unmatured RRSP.
Before RIFF payouts, each has an income of $37,000 so the minimum amount after splitting the pension income attracts tax at 20% Anything beyond that will be more. Going past $80,000 will make them subject to Old Age Security clawback, so for simplicity, let’s avoid that.
If they both died tomorrow, the tax bill would be quite large. In John’s case, about $190,000 and in Mary’s case, about $85,000. Would it pay to take income they don’t need now to make the estate tax lower? The answer is an unconditional maybe.
We know the minimum withdrawal rate will be less than 7% until Mary is 81. So the total balance will grow until then and gradually decline after.
Suppose they decide to take $30,000 extra this year. The tax at $15,000 each is about $4,200 each or a marginal rate of 28%. If they died soon it would save about $14,000 in the estate. So profitable in that narrow condition, However, the fund will earn $2,100 less investment income next year and it would not be taxed yet. If they invested the after-tax amount of $30,000 minus taxes of $8,400 $21,600 at 7%, their TFSA is full, they would pay tax on about $750 each and that would cost a total of $450. The government comes ahead by about 9,000 now and John and Mary’s estate saves $14,000 someday in the future.
How long until the tax cost now would grow to break even? How long would it take $9,000 given up now to grow to some number that makes me better off in the estate?
If I don’t take the $30,000 out, it will double in 10 years at 7% and quadruple in 20 years. Mary would be 85 then, so reasonably probable. $120,000 will be $60,000 after taxes. On the other hand, $21,600 growing at 5% after taxes would be about $57,000 in 20 years, so no profit yet. Mary would have to live past 87 to have a profit.
The younger you are, the less likely you can make any significant profit by drawing extra.
If they were 15 years older now, early withdrawals would win. At 80, you would still have to live 20 years to be a loser. You might but it’s less probable.
You can model this fairly easily with a spreadsheet.
If it matters or you want to have a way to judge quickly, build the model. You can get the minimum withdrawal rate here and a way to find the marginal tax cost here. Seniors have many more tax variables than the EY calculator will address. Calculate the difference in the tax and assume that all the adjustments are in the basic amount. It’s not quite true, but close enough to make a decision. Be careful with the OAS clawback.
The idea is to look for direction, not precision. The future will be more chaotic than the numbers can handle.
I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software startup, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning and business matters. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Federal Business Development Bank.
Be in touch at 705-927-4770 or by email at firstname.lastname@example.org.