Retirement Income Layering
Here’s the tax secret: Income layering of all your income sources in retirement can help you get a better after-tax result, and help you preserve your capital for the future, too.
Non-Registered Investments. Review the output of income-producing assets available for pre-retirement and retirement planning with your tax and financial advisors when assets are held outside an RRSP. Some options include:
· Debt instruments, generating interest: Interest, in general, is not tax-efficient when held outside an RRSP; 100% of accrued earnings are added and there are no offsetting tax credits. Also, in the case of compounding investments, you must pay the tax on accrued investments before you get the earnings. This means you dip into your own pocket to pay the tax first. Therefore, interest should be earned within a TFSA or a registered account if possible.
· Dividends from preferred and common shareholdings: Dividends can be more tax efficient, depending on your province of residence; dividends can even offset taxes payable on other income of the year, depending on your marginal tax bracket. However, be careful; an overweighting in dividend income can cause a clawback of Old Age Security benefits and other tax credits, as discussed.
· Accrued gains in income-producing assets: Very tax efficient, as those gains will not be taxed until disposition. At that time, they will then be offset by capital losses of the year, and after this only 50% of the net amount is added to taxable income. Additional planning with charitable donations can render capital gains on certain securities completely tax-free.
· TSWP mutual funds: This income can be tax efficient as it is made up of a combination of tax paid capital and earnings. You will be able to receive the monthly cash flow you need, while also minimizing the tax paid. However, a capital gain may occur in the future, as capital withdrawals reduce the cost base of your assets.
· Mutual fund distributions: Regular distributions from the fund—capital gains, interest and dividends—have a variety of tax consequences. Generally you’ll want to buy these investments at the beginning rather than the end of the previous year to avoid receiving all the distributions for the year over a short ownership period.
· Corporate class mutual funds: The capital class structure will allow you to protect against declining markets or buy into emerging markets by shifting capital into another class of shares of the corporation without triggering a capital gain.
Don’t forget the TFSA. Significant protection against inflation and taxation can be achieved when you take advantage of investment opportunities in a Tax-Free Savings Account, especially if all other tax deferral opportunities have expired. Otherwise, the return of your tax-paid capital can supplement taxable income, as discussed above, but at the expense of a diminishing balance on which to earn future income.
A proper retirement income layering plan can provide significant tax savings. Multiplied over an average retirement period of 20 years for each taxpayer the saving can run into the tens of thousands of dollars.