Tax-Effective Income

A vital part of your retirement income strategy is to minimize taxes. The less you pay in taxes, the more money you’ll have for an enjoyable, secure retirement. Fortunately, you have plenty of opportunities to save on taxes. They range from the tax shelter of RRSPs and RRIFs, to special tax breaks available only to retired Canadians, to tax-effective investment strategies.

Registered versus non-registered plans

The end of your RRSP doesn’t mean the end of tax-sheltered growth. As we’ve already pointed out, a RRIF enjoys the same tax breaks as your RRSP. You can’t inject new money into the plan, but the assets already there will continue to compound free of tax until withdrawn. That’s why it’s important to leave RRSP and RRIF assets untouched for as long as possible.

You don’t have to convert your RRSP until the end of the year you turn 71. If you retire before then, you can enjoy years of tax-free growth simply by leaving your RRSP intact. Once you convert, you can maximize tax-deferred RRIF returns by withdrawing the minimum amount every year.

If you plan to leave your RRSP or RRIF funds untouched for as long as possible, where will your money come from? You may have to rely on income from non-registered sources. You can also use these investments to supplement the income provided by a RRIF, annuity, or LIF.

Tax planning doesn’t end there, however. There are ways to make your non-registered investments more “tax appealing.”

One of the most effective strategies is to hold your non-registered investments in securities that generate capital gains or dividend payments, rather than interest.

Canadian-source dividends, which are eligible for the Dividend Tax Credit, are in most circumstances the most tax-effective type of investment income outside of an RRSP. Next in line are capital gains, because only half of a capital gain is actually taxed. Interest income enjoys no special tax status.

Income splitting can reduce taxes

With advance planning, you may be able to reduce your taxes even further in retirement. One of the best ways is through income splitting, a way of equalizing the income streams of you and your spouse.

Income splitting works because two moderate income streams are taxed less heavily than a single income stream of the same total amount. If most or all of the family income is attributable to one person, it’s likely to be taxed at a high marginal tax rate. In addition, if both spouses have income from eligible sources, they’ll both be able to claim the federal pension tax credit.

A spousal RRSP offers a convenient way to split retirement income. The spouse with the higher income can contribute to an RRSP that belongs to the lower-income spouse (total contributions to both the spousal and regular plan can’t exceed the annual limit.)

The lower-income spouse’s RRSP contribution limit is unaffected by the funds placed in the spousal plan. He or she can still contribute up to the yearly maximum. When the RRSP funds are eventually withdrawn as income, they’re taxed in the hands of the lower-income spouse. Some restrictions apply, however, to discourage quick withdrawals. Funds removed from a spousal plan in the year of contribution or the next two years are taxed as income in the hands of the contributor.

If you’re older than your spouse, a spousal RRSP may also allow you to continue making RRSP contributions past the age of 71. You can’t contribute to your own RRSP past that age, but as long as you have earned income, you can contribute to your spouse’s plan until he or she reaches 71. You still claim the tax deduction on the amounts you contribute.

You can split income outside of an RRSP as well, by using money earned by the lower-income spouse for investments. This will help even out the post-retirement income stream.

In addition, you can split Canada Pension Plan income with your spouse. This is worthwhile if you and your spouse are taxed at different levels or if your CPP benefits are very unequal.