Optimizing Withdrawals for Tax Efficiency in Retirement

When it comes to retirement planning, one of the most important considerations is how to strategically withdraw from your various investment accounts. The order in which you draw income from your investments can have a significant impact on your lifetime taxes payable and even the amount of taxes owed on your estate at death. While banks often recommend a simple approach of drawing from tax-free and non-registered accounts first, leaving registered plans to grow tax-deferred, this is often not the most tax-efficient strategy. In fact, a financially-optimized approach often involves tapping into registered plans earlier and allowing tax-free investments to compound.

Let’s break down these two approaches, the pros and cons of each, and why a more tailored approach to withdrawals has the potential to reduce taxes during your lifetime and on your estate.

The Rule of Thumb: Non-Registered and Tax-Free Accounts First

Many financial institutions advise retirees to begin withdrawing from their non-registered and Tax-Free Savings Accounts (TFSAs) first, while leaving their Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs) untouched for as long as possible. The logic behind this approach is simple: RRSPs and RRIFs are tax-deferred, meaning that the investments in these accounts grow without being taxed until you withdraw them. By delaying withdrawals from these accounts, your money continues to compound tax-sheltered for a longer period, potentially resulting in a larger total amount.

The Potential Downside

However, while this strategy might seem advantageous at first glance, it can lead to unintended tax consequences later on. Delaying withdrawals from RRSPs or RRIFs can result in larger required withdrawals once you turn 71, the age by which you must convert RRSPs into RRIFs. These larger withdrawals may push you into a higher tax bracket, resulting in higher taxes during your later retirement years. Additionally, you will almost certainly be receiving OAS payments which are clawed back if your income exceeds a certain amount. Finally, if significant amounts remain in your RRSP or RRIF at the end of your life, your estate could face a substantial tax bill, as the remaining balance is typically taxed as income in the year of death.

The Optimized Approach: Drawing from Registered Plans First

An alternative, more tax-efficient strategy involves withdrawing from your registered accounts earlier in retirement. This approach typically focuses on optimizing withdrawals by staying within a lower tax bracket, while simultaneously contributing any surplus withdrawals into a TFSA.

By making withdrawals from your registered accounts earlier in retirement, you can spread your taxable income over more years. This reduces the likelihood of large, mandatory withdrawals later pushing you into a higher tax bracket. As long as withdrawals stay in the lower tax bracket, you can withdraw more than you need for living expenses and contribute the surplus into your TFSA. The benefit here is twofold: TFSAs grow tax-free, and withdrawals from them are not taxed. This provides a tax-efficient way to continue growing your retirement savings.

Since TFSA withdrawals are tax-free, it’s generally advisable to use this account as your last source of retirement income. Because the withdrawals are tax-free, the growth in this account is never taxed. Allowing it to compound over a longer period of time will maximize your tax-free growth. This will also ensure you have a flexible, tax-free source of income later in life.

Benefits of the Optimized Approach

The most significant advantage of this strategy is that it reduces lifetime taxes. By taking withdrawals from your registered accounts earlier and keeping taxable income within lower brackets, you can minimize your overall tax burden.

Another major benefit is the potential to reduce the taxes owing on your estate. If you pass away with a large balance in your RRIF, it will be considered income in the year of death and taxed accordingly. By systematically drawing down your registered accounts earlier, you can lower the balance in these accounts, leaving a smaller tax liability for your estate.

A Practical Example

Consider a person who retires with $500,000 in an RRSP and $100,000 in a TFSA and who wants to make the money last from age 65 to age 100 (assuming 6.7% return on equity, 3.4% on fixed income and a balanced asset mix of 40% equities, 60% fixed income). If they don’t touch their RRSP until the TFSA runs out, they will have four years (ages 65 to 69) of withdrawing $40,480 per year from the TFSA during which they will pay no tax on withdrawals. Then they will roll the RRSP to a RRIF and continue to spend $40,480 per year until age 100, paying a total of $202,825 in tax in Alberta.

If, instead, they withdraw from the RRIF until it is depleted and then spend from the TFSA (same assumptions as above), they would spend $40,424 per year and a total of $150,770 in taxes in Alberta over their lifetime. The annual spending is virtually the same, but the lifetime taxes are lower, and if they die at an earlier age, there will be less or no taxes owing on the estate, leaving more for beneficiaries.

This example is hypothetical. Please contact me to discuss how it would work for you, based on your personal risk tolerance and objectives and your own unique assets, accounts and tax levels.

When it comes to retirement planning, the order in which you withdraw from your investment accounts matters. While the traditional advice of withdrawing from tax-free and non-registered accounts first may seem appealing due to continued tax-deferred growth, a more thoughtful approach can lead to significant tax savings over the course of your retirement. By drawing from registered accounts first and maximizing TFSA contributions, retirees can not only reduce their tax liability but also protect their estate from a large tax burden at death.

You can read more articles about tax-efficient strategies and other financial topics. If you have questions about this article or would like a conversation about how these ideas apply to your unique situation, call us at 403-290-0940.