The ins and outs of RRSP conversions

In the coming years as the baby boomers move into retirement, counselling clients on converting their registered retirement savings funds will become a big part of financial advisors’ practices.
RRSPs must be converted into RRIFs on December of the year that the holder turns 71, but RRIFs can be opened at any age as long as your client has RRSP assets. “But converting means that you are ready to draw income,” said Wilmot George, director, tax and estate planning, at Mackenzie Financial Corp. in Toronto.

The year after your clients set up RRIFs, they will have to withdraw a yearly minimum amount from their accounts. For RRIF holders under the age of 71, the yearly minimum is calculated according to this formula: the market value of the RRIF divided by 90, minus the owner’s age. At 71, the minimum withdrawal rate jumps to 7.38% and gradually escalates to 20% at age 94 and over. And because the payments are considered taxable income, they could put your clients into a higher tax bracket and expose them to clawbacks to the Old Age Security benefit.

“Because there was a tax advantage to contributing to an RRSP, clients need to recognize that they cannot avoid being taxed on withdrawals from their RRIFs,” said David Ablett, director, tax and retirement planning, Investors Group Financial Services Inc. in Winnipeg. “But there are some things they can do to mitigate the tax hit.”

One of them is the age your client states on the RRIF application. He can either use his own age or the age of his spouse or common-law partner. “If the spouse is younger, your client has the opportunity to make smaller mandatory withdrawals based on the younger person’s age, allowing for a longer period of tax deferral,” Mr. George noted.

Another strategy is requesting increased withholding tax on RRIF payments. RRIF payments are subject to a withholding tax of up to 31% depending on the province of residence and the amount redeemed. “If your client is receiving rental income, capital gains and dividend income, there’s no withholding tax on this income and it will be subject to tax at the end of the year,” notes Mr. George. “He can contact his RRIF issuer to request having more tax withheld on his RRIF payments to prepay the tax that would be owing at the end of the year.”

And clients who are 65 and older and receiving RRIF income can claim a pension credit for up to $2,000 of RRIF income. The federal credit is worth $300 and can be used to offset tax payable on any form of income. “And the client can split the RRIF income with his spouse on their respective tax returns, regardless of the spouse’s age,” Mr. George said. “And the spouse can also claim the $2,000 pension credit. So the family could be accessing $4,000 of the federal pension credit on one income.”

Jackie Read, a financial advisor with Edward Jones in Vancouver, noted that clients who don’t require their withdrawals for living expenses can contribute the money to a tax-free savings account where it can grow tax-free. “Or they can contribute the payments to a grandchild’s registered education savings plan. Like income-splitting with a spouse, this is a strategy to shift money from an individual in a high tax bracket to a person in a much lower tax bracket.”

Annuities
A way in which clients can completely avoid mandatory RRIF withdrawals is by purchasing life annuities with their RRSP assets. Annuities provide a set monthly income determined by the interest rates when the annuity is purchased. Some insurance companies offer inflation-protected annuities. And annuities can also be purchased with guarantees of up to 25 years; if the holder dies before the guaranteed period, annuity payments are made to his estate for the duration. Inflation protection and guarantees come with an added cost.

“Annuities give the holder a guaranteed level of income that may be important for the person who didn’t have an employer-sponsored pension plan and who is concerned about the possibility of outliving his savings,” said Mr. Ablett.

He provided a quote for a single life annuity with a ten year guarantee period from a large Canadian insurance company for a single, childless, 65-year-old woman who never participated in an employer-sponsored plan and has $300,000 in an RRSP. The annual income in this particular case would be close to $19,000 per year. “With CPP income of about $10,000 a year and OAS of about $6,000, she’d have a guaranteed combined annual income of about $35,000. But if she converted the $300,000 in RRSP assets to a RRIF, the amounts she’d receive would be heavily dependent on the investment returns that were generated. And, as the capital in the RRIF decreased, she’d be getting lower payments,” he comments. But buying an annuity wouldn’t make sense for clients who have a company pension, he added. “I’d advise them to convert their RRSPs to RRIFs, and do some tax planning.”

Clients who like the idea of a guaranteed income should consider annuities in conjunction with RRIFs, Ms. Read said. “If they put all their assets into annuities, they wouldn’t have access to large sums of money for emergencies.

“And annuities are not for anyone who wants to leave an inheritance because the holder is giving up his assets for an income stream,” she added.

The advisor needs to determine whether it’s crucial for the client to know that he has a guaranteed income for the rest of his life, Mr. George said.

Beneficiaries named on RRSP applications do not automatically carry over to RRIFs. “If your client doesn’t name a beneficiary for a RRIF, upon his death the assets will flow through the estate and not directly to beneficiaries, and they will be subject to probate tax in the provinces in which probate is applicable,” said Mr. George.

“Clients who want their spouse or common-law partner to inherit a RRIF can highlight the option to name the spouse or partner as either ‘successor annuitant’ or ‘beneficiary’ on the RRIF application,” he added.

“The successor annuitant designation allows spouses and common-law partners to receive the deceased’s RRIF based on the plan’s original terms and conditions, such as minimum payments based on the deceased’s age.”

Mr. George stressed the importance of making one last RRSP contribution in the year in which clients are converting RRSP assets to a RRIF. “They’ll get the tax deduction for the year and they’ll also get more money into the investment for future income needs.

“And clients who are over 71 and have a younger spouse can still contribute to a spousal plan. This is becoming more important as some people are now working well into their 70s.”