Thursday, March 12, 2015

Pumping Your Oil Wells

I bet you never thought you owned an oil well!  Anyone with a source of retirement income has one. It’s not surprising that many will have more than one. Multiple sources of retirement income come from government and employer programs as well as personal plans. Comparing these sources to oil wells is a great way to recognize the best way to pump income to support our lifestyle during retirement.  The “revenue” flowing into our hands from our “oil wells” may come from both taxable and non-taxable sources.  The typical questions, so often asked, are: from which one do I pump first and when do I start?  The usual answer is, “It depends.”  The reason the answer isn’t so simple is because everyone’s situation is unique.  Lifestyle, sources of income, age of retirement, and even longevity play a significant part in the decision process.  Because we are not the same explains why our retirement plans cannot be either.   However, certain guidelines can be followed when pumping income to meet our lifestyle and manage taxes effectively.  

A New Approach: “Topping Up to the Tax Bracket”  

At one time, you may have encountered learning new things and doing them by the book.  If the book says so, then it has to right. The textbook may be perceived to be the logical way initially until we start to put things into practice.  We then recognize potential problems through our experiences, only to realize our strategy needs to change. The reason I am sharing this prelude is that the information which first appeared in the financial planning courses said:

 “Postpone as long as possible the withdrawal of funds in registered plans in order to defer the income tax thereon.”

“Use non-registered funds before registered funds.”

Daryl Diamond, an expert retirement planner, realized this isn’t effective planning.  Deferring withdrawals from registered plans leads to a “very disadvantageous tax trap as you progress into your late 60s and beyond.”

  Buying Time and Your Retirement BlueprintYour Retirement Income Blueprint

In both his books, Buying Time and Your Retirement Income Blueprint, Daryl Diamond makes reference to the strategy, “Topping Up to the Bracket.”  This profound gold nugget of information helps understand the significance of keeping taxable income within the first tax bracket during retirement. Regardless whether our income is staged at $25,000 or $44,000, the tax rate remains the same. The lowest federal tax rate is 15% and in this example, Saskatchewan’s lowest tax rate is 11%.  If money has been stockpiling inside registered plans, waiting until we are age 71 to begin withdrawals from these types of plans, is not ideal. What is ideal is creating a steady taxable income stream as soon as a person enters retirement.   

If income cannot be contained to the first tax bracket, then the next obvious choice is to maintain income within the second tax bracket, which tops up taxable income to $89,401. The charts show when income surpasses the first tax bracket income, the tax rate is then 35% (Federal 22% and Provincial 13%). These marginal tax rates calculate the taxes prior to applying the personal tax credits. I associate personal tax credits as “gift certificates.”  Any credit which lowers tax is like a gift.   The average tax rate isn’t as terrifying as the marginal tax rates.

Once the calculations of taxes are understood, then we grasp the importance for having a consistent taxable income in retirement.  The situation is better when couples are able to share their eligible pension income with each other. Pension splitting was first introduced in 2007 to allow a person with a higher taxable income to reallocate income to their spouse who has a lower taxable income.  The benefits are obvious: a lower tax bill in their household means more money for other activities.
Different Oil Wells
To begin, we examine possible sources of available income at retirement.  Think of the Canada Pension Plan (CPP) and Old Age Security (OAS) as oil wells which will provide guaranteed income for life.  These wells will never go dry; however, the earliest Canada Pension Plan benefits can be “pumped” is at age 60. For now, Old Age Security is available at age 65.  Gradually the new rules will increase the eligibility to age 67.  If retirement is prior to age 60, then other sources of income will need to fill the void as shown below.   
Life annuity payments from registered pension plans are also oil wells which will never go dry.  Pension plans, either a Defined Contribution Plan converted to a life annuity or a Defined Benefit Plan, provide benefit payments for a lifetime.  Defined Benefit Pension plans are generally bridged with Old Age Security and the Canada Pension Plan. Prior to age 65, their pension benefits will be higher with the anticipation that when CPP and OAS begin, the amounts will blend to provide the same consistent income.
Other oil wells are RRSPs (Registered Retirement Savings Plans) converted to RRIFs (Registered Retirement Income Funds). RRIFs provide the greatest flexibility when coordinating the appropriate flow of income to top up to the tax bracket.

The total monthly income of $3,500 shown in the above projection is all taxable income.  If both spouses maintained the same income level ($42,000), topped-up to the first tax bracket, their combined annual income would be $84,000. They may not spend all this income. Ideally, they’re converting a portion of registered to non-registered savings in a tax-effective matter.  The excess money can be sheltered in a Tax Free Savings Account (TFSA) until the funds are required without any further tax consequences.  

 The intention is to introduce a new way of understanding how to derive consistent income tax-efficiently in retirement.  Investment assets inside a sheltered vehicle, like a pension plan or RRSP, eventually needs to be withdrawn.  At age 71, any registered plan has to be converted to a retirement income fund.  In most cases, sooner rather than later works the best. Combining taxable income with non-taxable sources, utilizing pension splitting, and taking advantage of other tax shelters like TFSAs, are strategies to reduce taxes while keeping income within range of the first tax bracket whenever possible.  Take a look at how you manage your oil wells to determine whether you are doing the best job you can of reducing taxes while maintaining maximum retirement income.

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