Saturday, July 14, 2012

Going for the Long Haul

10:23 AM

Withdrawal order

Life is not a sprint, it's a marathon. So you must pace yourself and spend just the right amount during retirement in order not to run out of money.

This is where more saving, more investing, and less spending will improve your odds. Your withdrawal strategy can also help stretch out your savings.

Here are a few ideas on planning your retirement income.

There are a few schools of thoughts, but I am a fan of withdrawing money in the following order:

  1. Taxable account (non-registered investments)
  2. Tax-free savings account (TFSA)
  3. Locked-in Retirement Account (LIRA)
  4. Registered retirement savings plan (RRSP)

Essentially, the strategy is to take money first from accounts where the withdrawals are non-taxable or minimally taxed withdrawals.

The idea is to that investment income from a non-registered account is taxable, so your net after-tax rate of return is lower than the tax-free rate of return from a registered account. Since investment income compounds over time, you achieve greater compounding with higher returns and it makes a big difference over time.

Registered funds enjoy tax-free growth but are taxed as income when withdrawn. You can withdraw just enough to meet your needs and minimize taxable withdrawals. These taxable withdrawals will be partially offset with age and pension income deductions, and possibly higher medical expenses deductions.

Your RRSP has to be converted into a registered retirement income fund (RRIF) by the end for the year during which you turn age 71. A minimum withdrawal must be taken each year from a RRIF, based on age-related factors. Similarly, if you have a LIRA, it has to be converted into a life income fund (LIF) at the same time. Depending on the provincial jurisdiction for the LIF, withdrawals will be typically limited to the RRIF's age-related minimum, but may not exceed a maximum amount as well.

So you have to take the minimum RRIF withdrawals to avoid penalties. It is a good idea to take the maximum LIF withdrawals, and save any excess not required for your budget. This will speed up access to locked-in money, so it will be there when you need it. You can invest the funds in a tax-effective manner to defer tax on investment income on these newly released funds.

If you have large unrealized capital gains from a taxable account, the deferral of taxation in such cases is Going for the long haulsimilar to the registered account, so the benefit of withdrawing from non-registered first may not matter as much.

Stretching money a few more years

Here's an example to illustrate my point.

Suppose you have $200,000, half in a registered retirement income fund (RRIF) and the other half in a non-registered account.

You want to receive 4% of your assets after-tax each year. So you'll need to take 5% from the registered account to get 4% after-tax based on the assumptions below.

Here are the assumptions:

  • Investment return: 5%
  • Tax rate on investment income from non-registered account: 40%
  • Tax rate on withdrawals from RRIF account: 25%
  • Non-registered investment income fully realized each year

The chart below shows the outcome if you withdraw all your registered assets first and then dip in your non-registered assets.

You run out of money in 2037.

The second chart shows the outcome of withdrawing all non-registered assets first and then using registered assets. In that case, money runs out in 2040.

All other things being equal, what happens when you use non-registered assets first?

You get leverage from compounding tax-free investment returns as opposed to the lower compounding of after-tax investment returns.

And this will make your money last an extra three years in our example.

TFSA or RRSP first?

I tend to favour withdrawing funds earmarked for retirement in a TFSA before going to the RRSP or LIRA.
The TFSA is a flexible vehicle, but you need contribution room to take advantage of the flexibility. You create more room as withdrawals from a TFSA restore contribution room.

So in years you actually have to withdraw more than you need from a RRIF because of the minimum annual withdrawal, you can at least deposit some or all the funds in the TFSA to continue earning tax-free investment income on the excess money.

Also, as most of your assets will be concentrated in an RRSP or LIRA, the more you defer, the more compounding you earn when you minimize withdrawals and have all your money invested.

TFSA at a Glance

Here's a quick overview of how the TFSA works.

  • Starting in 2009, Canadians age 18 and older can save up to $5,000 every year in a TFSA.
  • TFSA contributions are not deductible.
  • Contributions to a TFSA are not deductible for income tax purposes but investment income earned in a TFSA (including interest, dividends and capital gains) will not be taxed, even when withdrawn.
  • You can withdraw funds from the TFSA at any time for any purpose.
  • Unused TFSA contribution room can be carried forward to future years.
  • The amount withdrawn can be put back in the TFSA at a later date without reducing your contribution room.
  • Neither income earned in a TFSA nor withdrawals will affect your eligibility for federal income-tested benefits (such as the Old Age Security, Guaranteed Income Supplement and the Canada Child Tax Benefit) and credits (e.g. age credit and GST credit).
  • Contributions to a spouse’s TFSA are allowed and TFSA assets can be transferred to a spouse upon death.
  • Maximum TFSA contributions increase each year in line with the inflation rate, to the nearest $500.
  • TFSA contributions are independent of (and in addition to) RRSP contribution limits.

Use of TFSA

One last comment on the TFSA. It's a great vehicle to hold funds for emergency. You can invest in low risk fixed income and pay no income tax on investment income.

This provides you with a better return and more impact from compounding.

Depending on how much you need for emergencies, any excess can serve as a source of retirement income.

Deciding where to withdraw first

Your circumstances may call for a different strategy than what is suggested here.

But knowing the characteristics and capital available in each type of account, you can start planning for the withdrawals each year in the future.


  1. Error in above post

    "Contributions to a TFSA are deductible for income tax purposes"

    1. Thanks Tron! A "not" was missing in this sentence and has now been inserted.

  2. Why is the tax rate you used for RRIF withdrawals so much lower than the tax rate on the non-registered investments?



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