How to Convert Your RRSP to Income
Registered Retirement Savings Plans
represent one of the most significant retirement planning
tools for Canadians. There are a number of ways to put your RRSP money to work during retirement, but they all boil down to a simple concept. The money you accumulated during your years of saving and investing is converted to a vehicle that provides you with retirement income
. Instead of making contributions, you will rely on withdrawals from your nest egg to subsidize your retirement expenses. Instead of saving money
it’s time to spend it!
When is the best time to convert your RRSP into income?
The best time to convert your RRSP into income is when you need to. Typically, this occurs when you retire and have no paycheques from work. The ideal situation
is to contribute to an RRSP in your ‘earning years’ when you are paying taxes in a higher marginal tax rate
and then withdrawing the money later when you have no other sources of income (like in retirement). Taking income from the RRSP while you are still working can be very costly and will negate the benefits you derived from contributing in the first place.
That being said, you could convert RRSPs to income as early as age 18, but should wait until later in your life.
How long can you defer the RRSPs?
Many pundits will advise that you should defer your RRSPs for as long as you possibly can. While this may be true in most circumstances, it is a rule of thumb and does not apply in all circumstances. Most people defer the decision to convert RRSP into income so they can defer the tax. Canadians hate to pay taxes so much that they avoid any withdrawals from the RRSP until they are forced to do so. Sometimes deferral can be the costly alternative
. Government rules stipulate that you must wind up your RRSP by the end of the year in which you turn 71.
Basically, you must convert your RRSP into a Registered Retirement Income Fund (RRIF) or life annuity in the year you turn 71, but you do not have to start that income in the year you turn 71. It must start in the following year.
If you turn 71 this year and you have not converted your RRSP into an income vehicle, you need to see your financial advisor or financial institution before December 31.
What are my income options?
Today, most people will convert the RRSP into a RRIF, but this is not the only option you have available to you. In fact you, have four alternatives:
1. Cash out the RRSP
. While this may be an option, it is not usually a good one. Cashing out means that the full value of your RRSP is added to your income and taxed accordingly. Unless you have a very small amount, this can mean a significant part of your wealth will go to the government. Remember that when you cash out the RRSPs withholding tax
is applied but the total tax owed is based on your marginal tax rate.
3. Life Annuity
. Think about a pension plan and that will help you to understand what an annuity is. Just like a pension plan, an annuity is simply a tool that provides you with a fixed stream of income that is guaranteed for the rest of your life. Regardless of markets, interest rates, inflation or the economy, your cashflow remains stable and fixed for your lifetime. There are also reasons why annuities make sense
4. Fixed Term Annuity. Unlike the life annuity, the fixed term annuity does not pay you an income for a lifetime. Instead, you choose a fixed term like 5, 10, 20 years, etc. The only stipulation is the term cannot extend past the age of 90.
How do you know which option is best for you?
The easiest answer is good planning. Different people will have unique circumstances and needs. These issues will determine which option(s) is best suited for you.
Remember that it is not an all or nothing situation where picking one of the options means you cannot choose other options. Sometimes a combination may be the ideal solution.
I can offer some important considerations when comparing RRIFs to annuities.
· Flexibility of income or investment choice – If you are looking for flexibility to set up the income the way you want, with the option of making changes in the future, the RRIF winds hands down. On the other hand, flexibility and choice can be a curse for some who prefer to keep it simple and secure. In these cases, an annuity might make more sense.
· Control – Some people want control, while other just want to be able to set something up and let it run on autopilot. Annuities have the distinct advantage of being easy to set up and understand. RRIFs require more decisions and more management.
· Estate preservation – Generally, the best alternative to provide an estate benefit is usually through the RRIF. You can provide an estate with life annuities if it is set up with proper guarantee periods, but these options can reduce your level of income.
· Spousal protection – Providing survivorship options for your spouse can be facilitated under any route you choose (RRIFs or annuities). However, in the case of annuities, you must make sure they are set up properly.
Wealthing Like Rabbits: just sound financial advice
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” –Albert Einstein
Rabbits breed quickly.
Unfortunately, your money grows far more slowly, hence the importance of compound interest.
One of the secrets to accumulating wealth is to get compound interest working for you as early as possible. There’s no mystery to compound interest. As simple as it is, few of us are invested long enough to let compounding work its magic.
In his excellent book, Wealthing Like Rabbits, author Robert R. Brown has set out to educate younger people with sound financial advice on the things they need to know to become financially successful.
Brown’s book seems written for people in their 20s and 30s. One of the biggest money mistakes people make is spending money we don’t have on stuff we don’t need to keep up with people who don’t matter. I see this in clients of all age groups, but particularly in my younger clients, who seem unwilling to put off big purchases until they can afford them.
As Brown writes, “Far too often we see Buddys and Buddy-Lous out there spending money they don’t have on things they don’t need so that they can appear wealthier than they are in a futile attempt to keep up with those damn Joneses. Screw the Joneses!
“And, by the way, the Joneses probably aren’t as well off as they look either. . .sadly, beneath the imitation wealth and artificial happiness there is often a lot of very authentic debt and stress.”
If you read The Millionaire Next Door, another excellent book, you’ll learn that most wealthy people don’t appear wealthy because they don’t flaunt it. They live in ordinary houses, drive ordinary cars and live ordinary lives. On the other hand, the Joneses next door may appear to be rich but may be up to their eyeballs in debt to live their lavish lifestyle. As Brown says, forget what others are doing or how “rich” they appear to be.
Those who think that living it up is fun are often beset with money worries. Big debts are very stressful, and I’m convinced that those people don’t enjoy life as much as they would if they had less stuff that they don’t need – and less worry.
Personal finance doesn’t have to be dry and boring, which Brown proves with this entertaining book. He combines clever story telling with humour and commonsense advice. I’m convinced that anyone who follows Brown’s recommendations will be far better off for it.
In one of my favourite stories, Brown talks about the famous video-game Mario Brothers as they look for homes with bags of golden coins. With the bank’s endorsement, Mario takes on a big mortgage to purchase a large home. His wiser brother Luigi, on the other hand, chooses a more affordable home.
As Brown reminds us, banks are in the business of making money. Unfortunately, their goals rarely align with ours, which often leads to encouraging customers to take on too much debt. Banks, he points out, “are not in the business of ensuring that your house purchase is a smart decision for you and your long-term financial health.”
This book is full of commonsense advice that, if practiced faithfully, can set you up for success. Opportunity costs, debt, credit cards, lines of credit, RRSPs, RESPs, home buying, mortgages, budgets…it’s all here, and written in a style that will entertain and educate.
While the advice seems written for folks in their 20s and 30s, it’s quite appropriate for older Canadians. My experience is that those in their 40s, 50s and 60s generally have not mastered the
3 Important Pension Plan Changes for Alberta
There are big changes on the way for pension plans in the province of Alberta. Alberta is the latest province to modernize its pension legislation, following in the footsteps of Ontario. These pension plan changes have been on the works for quite some time. B.C. will soon come out with new rules of its own.
Effective September 1, 2014, a number of new rules come into effect in Alberta. The new rules are far-reaching, impacting not only pensions plans registered in Alberta, but any provincially-regulated pension plans with Alberta members.
If you’re a plan sponsor with employees in Alberta, you’ll need to start following the rules. There are many pension plan changes but in this post, I highlight three key changes plan sponsors will need to follow effective immediately.
Following provinces like Manitoba, Ontario, and Quebec, effective September 1, 2014, Alberta members are now immediately vested. What is vesting? It means members are entitled to their full pension benefits when they leave an employer. Before the new rules, Alberta members had to wait two years to become vested. If an employee leaves on or after September 1, 2014, they’ll receive a pension payout. The new rules make it more costly for plan sponsors – members who were previously non-vested will receive a payout.
There are a number of things plan sponsors can do counteract the change. Plan sponsors may want to extended membership eligibility to two years. That way a member will have to accrue service for two full years before they can join the pension plan and be entitled to a payout. With the trend towards immediate vesting, to make pension administration easier, plan sponsors may want to consider offering immediate vesting across the board.
Unlocking: Small Pensions
The small benefit test has been changed in Alberta. If a member is vested and terminate their employment before their earliest retirement date, they’ll be able to choose to receive a pension payout in the form of a deferred pension or the commuted value. Normally a member’s pension is locked-in until retirement, unless it falls under the small pensions threshold.
Previously, there were two tests to see if a pension would be considered a small benefit. The first test that compared to the current year’s YMPE (Years Maximum Pensionable Earnings) to the annual pension at normal retirement date (NRD) has been eliminated.
The only test to see if a pension qualifies as a small benefit is now whether the commuted value is 20% or less of the YMPE in the year of termination. For example, if the annual pension at NRD is less than $10,500 (2014 YMPE: $52,500 X 20% = $10,500), then it’s considered a small benefit and the member is entitled to receive is as a cash lump sum or transfer their pension to a non-locked in savings vehicle like their RRSP. The new rules means there will be less small pensions, which means a greater number of plan members on the books.
Effective December 31, 2014, pension plans with Alberta members must start issuing inactive statements. The new rules require that annual statements are to be provided to retirees in pay (pensioners and surviving spouses). Similar to active statements, inactive statements must be provided 180 days after the pension plan’s year end (starting June 2015). Although this will create additional work for plan sponsors, the good news is that statements are not required for deferred vested members
3 adjustments made to CPP after it’s in pay
I did some calculations for a client recently to help her decide when to take her Canada Pension Plan (CPP) retirement pension. She decided to take her pension now, but the amount showing in the letter she received from Service Canada wasn’t what she expected.
Mary (not her real name) was born in July 1954. She had relatively low earnings until age 28 and then earnings above the YMPE (Year’s Maximum Pensionable Earnings) level ever since. She had been planning to retire next year when she turned 61 and was wondering whether she should take her CPP now at age 60, next year when she retires, or at age 65.
Based at least partly on my calculations, Mary decided to take her pension now, at age 60. However, when she received her award letter from CPP, she was surprised to find that it showed an amount less than I had said she would be entitled to.
I reminded her that my calculations included credit for her 2014 earnings, and that she should receive a retroactive adjustment to her CPP once Service Canada has confirmation of those earnings when she submits her income tax.
I realized that she was going to have several adjustments made to her CPP next year and such adjustments are not always well explained by Service Canada. These same adjustments will be made for most people who are still working in the year that they start receiving their CPP, so I thought this issue might be a good subject for this month’s article.
I told Mary that she should have three adjustments made to CPP in 2015, which should occur in the following order:
1) Annual cost of living adjustment
In January 2015, her CPP should increase from her 2014 amount based on any increase in the cost of living as measured by the CPI (consumer price index). Based on recent years, this increase will likely be in the range of 1 to 2%. This annual cost-of-living adjustment will be made to her CPP every January.
Mary will be eligible for the full annual increase for 2015, even though her CPP only started in August 2014.
2) Post-retirement benefit increase
Since Mary’s CPP was effective August 2014, and since her 2014 earnings exceeded the YMPE, her prorated earnings from January to July will be used to calculate her regular CPP retirement pension, and her prorated earnings from August to December will be used to earn her an additional PRB. This PRB will be effective January 2015, but she shouldn’t expect to receive it until sometime between April and June 2015, with retroactivity to January.
A similar PRB adjustment will be made for her in 2016 (based on her 2015 earnings) and in any subsequent years that she has earnings from salary or self-employment and makes a CPP contribution on those earnings.
3) Increase for 2014 earnings prior to CPP
When Mary’s CPP was first approved, the award letter explained that it was an “interim” calculation which may not include all of her earnings. This is because her 2014 earnings details won’t be available to Service Canada until after her 2014 income tax return is filed and assessed by Canada Revenue, sometime in 2015.
This adjustment should likely happen sometime between September and November 2015, with full retroactivity to August 2014. Sometimes however, Service Canada seems to “forget” to make this adjustment without a reminder telephone call.
At a minimum, CPP pensions will be adjusted at least once a year. The letter from Service Canada (if any) doesn’t always do a good job of explaining the reason for the adjustments made to CPP.
Hopefully this article will help explain the reasons for and the timing of possible adjustments, but fire away if you have any questions!