3 RRSP Withdrawal Mistakes and How to Avoid Them
Retirement comes with the need to build new skills. Instead of having a single paycheque, you will have to learn how to plan for multiple income sources. This gives retirees a lot of flexibility, but there are also challenges to be aware of. In this article, we’ll look at some mistakes that retirees typically make when drawing on their RRSPs.
Forgetting about withholding taxes
Unexpected tax bills are never fun. Unfortunately, many retirees find that they owe money to the CRA during the first few years of retirement. This happens when withholding taxes aren't set high enough. The taxpayer will then have to pay the balance of their taxes owing by the end of April. If they don't, interest and possibly penalties will be added on top of the amount owing.
The default options for withholding taxes can lead to thousands of dollars owing come tax season. Each source of income is independent, and will only withhold the minimum required tax unless you notify them to take more. Because retirees no longer have a payroll department to rely on, they have to do their own calculations to make sure that enough tax is deducted.
Withholding tax rates on RRSP withdrawals are tiered based on the amount withdrawn:
10% (5% in Quebec) on amounts up to $5,000
20% (10% in Quebec) on amounts over $5,000 up to including $15,000
30% (15% in Quebec) on amounts over $15,000
Example: If someone were to make 3 withdrawals of $4,000 (total of $12,000) in a year, they would have 10% tax deducted each time. A total of $1,200 would be sent to the CRA to prepay taxes for the year. But if the same person had other income and their average tax rate was 25%, then this wouldn't be enough. The total tax on their RRSP withdrawals would be $3,000, leaving them in a tax shortfall of $1,800.
Doing preliminary tax calculations during the last few months of the year can allow you to estimate your coming tax bill. This is particularly useful in years when you start a new source of income, such as CPP or OAS.
Preparing for tax season
Use a tax calculator to estimate your total tax bill for the year.
Compare the projected bill with the amount of withholding tax deducted from each source of income.
If not enough tax has been deducted, start putting aside money for when the balance becomes due at tax season.
To fix this for the following year, you can get one or more of your income sources to start deducting more tax. If you have a large balance owing in multiple years, the CRA may require you to start paying instalment payments.
Missing out on tax benefits at age 65
Most people know that age 71 is when RRSPs have to be converted to a RRIF. Less known are the tax benefits of transferring at least a portion of your RRSP at age 65.
RRIF withdrawals have a couple of benefits over RRSP withdrawals once the account holder turns 65. In that year, withdrawals from RRIF become eligible for the pension income amount tax credit and pension income splitting. These two tax advantages can result in thousands of dollars saved each year.
You'll eventually get the benefits when you convert at 71, but a partial RRIF conversion could allow you to access them sooner.
Note: A RRIF account has the requirement a minimum amount be taken out each year. This is based on your age and the balance at the end of the previous year. Because of this, it's important to make sure that this extra income fits within your overall retirement income plan.
Not having a long-term strategy
The largest RRSP mistake retirees make is not having a long-term plan for investment withdrawals. Minimizing taxes in the current year can be at odds with an overall tax strategy. With a plan, it's possible to reduce lifetime taxes, improve cash flow, and keep estate taxes to a minimum.
RRSPs are tax-deferral accounts. You get a tax deduction when you put money in, but you will eventually have to pay tax when taking the money out. Because of this, the spending power of your RRSP is less than you think. This is why it's important to have a plan to take full advantage of the lowest tax brackets.
For example, It's common for one spouse to retire first while the other continues to work. In these situations, the couple will often try to live mainly on the income of the working partner. If the retired spouse doesn’t have a pension, they could have very little taxable income. This could be a missed opportunity to withdraw registered money at the lowest possible tax rate.
Without other sources of income, the retired spouse may consider making withdrawals from RRSP while their income is low. If the money isn't needed for expenses, it could be used to fund their TFSA. The couple would then have greater flexibility to make tax-free withdraws from TFSA in the future.
Would this strategy be appropriate for your family? It's impossible to say without knowing your priorities and having a long-term income plan. Investing in a retirement plan can allow you to structure your income to avoid tax surprises and maximize the value of your RRSPs.
If you'd like some help with your retirement income plan, you can schedule a free consultation with me.
