For many years, Canadians have been conditioned by investment industry marketing to focus on maxing out their RRSP contributions to realize as much income-tax deferral as possible.
While reducing taxes is always enticing, a tax minimization mindset may not be the best approach in the short term, especially for high-net-worth individuals. Instead, you should cultivate a tax optimization mindset.
What is a tax optimization mindset? It’s thinking not just about the current tax year, but how your assets will evolve over the long-term and planning to fund your retirement in a tax efficient way.
We like to discuss this issue with our clients by getting them to imagine three buckets. In the first bucket is assets in registered accounts – RRSPs, Registered Retirement Income Funds (RRIFs) and other similar accounts. When you withdraw money from them, you pay income tax on it.
The second bucket is for non-registered investment accounts and Tax-Free Savings Accounts (TFSAs). Here, income tax has already been paid on the money that went into the account, so you don’t have to pay when you withdraw funds from these accounts. Obviously, if you realize capital gains in these non-registered accounts, 50% of these gains will be taxed at your marginal tax rate.
The third bucket is for business owners who have moved earnings from their operating company into an investment holding company to defer paying personal income tax. Many entrepreneurs accumulate large amounts of money in their holding company and eventually have to pay tax on it, just like on their RRSP savings.
As they head to retirement, people are often focused on the year they will turn 71, knowing they must convert their RRSP into a RRIF by the end of that year. However, they fail to plan for the tax implications of having huge amounts of money in buckets one and three – accounts where they will have to pay income tax on withdrawals.
They work on the assumption they’ll have a large pool of savings to draw on during their retirement but, in reality, they could have only half the amount in after-tax dollars. What’s more, their mandatory RRIF withdrawals might trigger clawbacks on their old age security pension.
That’s why it’s so important to plan early for how you will fund your retirement tax efficiently.
Your plan should include maxing out your TFSA contributions. As I explain in this article, there are no taxes to pay on capital gains, interest or dividends in a TFSA and you withdraw your money from it free of income tax. That makes your TFSA a highly attractive investment vehicle that gives you tremendous flexibility in retirement income planning and in distributing assets to your children upon your passing.
Besides taking full advantage of your TFSA, your retirement income planning may also involve withdrawing money from your RRSP and holding company in the years before you reach age 71 to reduce your tax bill after that age.
While the right mix of assets in different accounts will depend on your individual circumstances, it’s never too early to take a long-term view and start planning.
With the end of the year fast approaching, it’s also time to make sure you’ve made all the moves you need to for your 2022 income taxes. These may include crystallizing capital losses to offset capital gains, making charitable donations and several other possible actions we discuss in detail in the latest episode of our Capital Topics podcast.
While tax planning keeps us busy at this time of year, please remember that optimizing your taxes should be a year-round process and that we’re always here to help.