Avoiding Tax Surprises in Retirement
Retirement can be a time of relaxation and enjoyment, but it also brings new challenges. One task that many retirees have difficulty with is managing their taxes. Unlike when you were employed, you'll no longer have a payroll department to deduct the right amount of income taxes.
This means that you'll need to keep track of your various income sources and set an appropriate amount of tax to be withheld from each. Failure to do so could result in unpleasant tax bills in the first few years of retirement.
After a few years of high tax bills, the Canada Revenue Agency (CRA) may force you to start making instalment payments. To avoid these kinds of surprises, it's important to take a proactive approach to tax planning. By doing so, you can enjoy your retirement without worrying about tax surprises.
Brian’s tax shock
Brian is 65, single, and retired at the end of 2021. He lives in Manitoba, and 2022 was his first full year of retirement. Let's break down his income sources and tax deductions for the year:
Workplace pension: $30,000
Tax prepayment: $2,400 (Brian didn't notify his former employer of his other income, so they withheld taxes as if the pension was his only income)
CPP and OAS combined: $17,000
Tax prepayment: $0 (By default, no income tax is withheld from CPP and OAS. Brian didn't request a change in this arrangement.)
RRSP withdrawals: 3 withdrawals, each for $4,000
Tax prepayment: $1,200 (Withholding tax rates on RRSP withdrawals are tiered based on the amount withdrawn.)
In total, Brian's taxable income for the year was $59,000, and the amount of tax sent to the CRA throughout the year was $3,600. However, based on his income and province of residence, his total income tax bill for the year was about $11,800. This leaves Brian with a tax bill of $8,200 — an unpleasant surprise for his first year of retirement.
Why did this happen?
Withholding taxes are prepayments for your annual income taxes. They are deducted from most sources of income and sent to the CRA. When you complete your income tax return, you will get a refund if you paid too much, but there will be a balance owing if not enough was deducted.
Brian went from a single source of employment income to multiple small streams of retirement income. Because each income source isn’t aware of Brian’s other income, the default is for them to take off low, or no, withholding tax.
The amount of withholding taxes won't change the total amount of tax Brian pays for the year. But by not pre-paying his taxes throughout the year, he could find himself unable to pay when taxes come due in April. If he misses the payment deadline, he could face interest charges and penalties.
If Brian had been proactive, he could have requested that each of his income sources take off additional tax above the required minimum.
What to watch for
Each time you start a new source of income in retirement, you should start thinking about withholding taxes. The initial amount of withholding tax likely won’t be enough.
A tax calculator can be used to quickly estimate how your total tax bill will change with the additional income. Once this is known, you can request that the withholding taxes be set to an appropriate level.
Instalment payments
Being hit with a big tax bill is unpleasant. It is especially hard for retirees who don't have the cash to pay before the deadline. Interest would then be charged on the outstanding tax balance. This can be extremely stressful for new retirees.
Additionally, fixing the withholding taxes can make it even harder to catch up on last year's tax bill. Once withholding taxes are correctly increased, there will then be less money going into your bank account each month.
If Brian doesn't increase his withholding taxes, he may need to start making quarterly instalment payments. If Brian neglects to make the required instalments, he could face interest and penalties on the missed payments.
Take control of your tax planning
You can avoid tax surprises by understanding withholding taxes and being proactive.
Remember to:
Review each new income source and find out how much tax is being withheld.
Use a tax calculator to estimate your total tax bill and make adjustments to your withholding taxes if necessary.
Stay informed about changes in tax regulations.
Consider seeking professional advice to help you make informed decisions about your tax planning.
Don't let taxes sour the start of your retirement. By taking charge of your finances, you can create a worry-free transition into retirement.
If you'd like some help with your retirement income plan, you can schedule a free consultation with me.
