Most Canadians have heard of RRSPs turning into RRIFs but fewer understand RRIFs. And fewer still understand how a RRIF can become a costly surprise for low-income seniors.
We have already published the parable of Cinderella and the three gifts of retirement. Now let’s unpack this historically and analytically:
1957: The RRSP is born
The RRSP was introduced in 1957. The idea was straightforward: encourage Canadians to save for retirement by allowing them to deduct contributions from taxable income and defer tax until later. They earn RRSP room generally at 18% of their wages.
1978: The RRIF joins the family
Twenty-one years later in 1978, the RRIF arrived. As in the folk tale Cinderella, something unwelcome happens at the stroke of a particular midnight and there is a policy-based curfew. You can no longer contribute to your own RRSP after December 31 of the year you turn 71. By that same date, you are required to close your RRSP and convert it into a RRIF or an annuity; you must begin taking minimum withdrawals by age 72 and you cannot put any more money into your RRIF.
The RRIF—or Registered Retirement Income Fund—was created because governments eventually wanted the income tax they allowed as a refund to come back to them. An RRSP allows money to grow tax-deferred, but not forever. By the end of the year in which a person turns 71, all RRSP assets must be converted into either an annuity or, more commonly, a RRIF. Were they thinking of the Cinderella story? We can only guess.
Think of it this way:
For decades, the RRSP is a tax-sheltered carriage carrying your retirement savings forward. At age 71, the carriage turns into a RRIF pumpkin and just like what happens in Cinderella, there are many outcomes following the carriage’s transformation back into a pumpkin.
Common to all versions, the government now requires minimum annual withdrawals, and those withdrawals add to taxable income.
But for higher-income retirees, that may not be a major concern. They expected to pay tax eventually in any event, just at a lower rate.
RIFF and a low income
For lower-income seniors, however, the real issue is often not income tax at all. It is the Guaranteed Income Supplement (GIS).
The GIS is one of Canada’s most effective anti-poverty programs. It provides additional income to low-income seniors on top of Old Age Security. But it comes with a catch: most additional income reduces GIS benefits.
For GIS recipients, every additional dollar of RRIF income can reduce GIS by roughly 50 cents.
This means a lower income senior may face something like this:
- $1,000 withdrawn from a RRIF;
- a $500+ reduction in future GIS;
- plus, whatever income tax may apply.
For many low-income seniors, the GIS clawback is far more significant than the income tax they may have to pay especially if they have to suddenly withdraw a lot of money out of the RRIF to meet an unforeseen financial obligation.
This reality creates a very different retirement planning landscape than the one often described in financial magazines or on retirement income podcasts or shows.
A higher-income worker may reasonably focus on maximizing RRSP contributions up until they retire. A future GIS recipient needs to think differently.
2009: Youngest sibling TFSA arrives
This is where the Tax-Free Savings Account enters the story.
Introduced in 2009, the TFSA changed retirement planning for millions of Canadians. Unlike RRSP contributions, TFSA contributions are not tax deductible and attract no tax credits. Canadians earn standard amounts of TFSA ‘room’ by breathing Canadian air legally while residing in Canada. That total room now exceeds $100,000.
The huge advantage of a TFSA is that withdrawals are tax-free. More importantly for low-income seniors, TFSA withdrawals do not affect GIS.
That distinction is crucial.
Money inside an RRSP eventually becomes RRIF income. Money inside a TFSA remains tax-free and free from GIS clawbacks. As a result, many Canadians who expect to receive GIS in retirement are better served maximizing TFSA contributions.
That statement can surprise people because the RRSP has long been presented as the gold standard of retirement savings. Most seniors who are GIS bound are not thinking about unloading their RRSP before age 65 but they should think about that carefully. Often, they should endure that tax pain of unloading the RRSP prior to age 65 and placing the net proceeds into a TFSA if they have TFSA room.
But retirement planning depends on circumstances. For a future GIS recipient, an RRSP deduction received at a modest tax rate during working years can eventually trigger decades of GIS reductions in retirement.
A wrinkle
Some retirees choose to establish a RRIF before age 71.
Why?
Because RRIF income qualifies for the federal pension income tax credit beginning at age 65. Even relatively small RRIF withdrawals can allow seniors to claim a valuable tax credit.
For moderate-income retirees, this can be a useful strategy.
For low-income seniors expecting GIS, however, the calculation becomes more complicated because every RRIF withdrawal can affect GIS entitlement.
The pension tax credit may help but many GIS recipients do not have pensions.
A financial shock after age 71: What do I do when I have to shrink my pumpkin?
This brings us to an often-overlooked issue. Financial shocks do not stop at age 71. Roofs fail. Cars die. Adult children need help. Uncovered health expenses emerge. Long-term care costs arrive. And life continues.
Suppose a senior suddenly needs $20,000 or (shudder) $200,000. Where should the money come from? For rich seniors, they simply write a check or e-transfer the dough. Easy peasy.
But low-income seniors often have to look to their registered instruments for the money. If it comes from a TFSA, there are no tax consequences and no GIS consequences.
If it comes from a RRIF, the withdrawal may generate an income tax liability and will trigger GIS reductions. In effect, the largest government recovery will occur at precisely the moment the senior is facing their greatest financial challenge.
That is one of the least understood features of Canada’s retirement income system.
The conventional wisdom says that RRSPs help Canadians save in income taxes payable. For many people, that is true.
But for low-income seniors, the more important question is often not: “How do I reduce my income taxes payable?” It is: “How do I avoid losing GIS?”
That is why retirement planning cannot be reduced to slogans. RRSPs, RRIFs, TFSAs, OAS, GIS, taxes, and clawbacks all interact.
For higher-income Canadians, the RRSP remains a powerful tool. For lower-income Canadians who are likely to receive GIS, the TFSA is the more valuable shelter.
The lesson is simple. The best retirement account is not the one with the biggest tax deduction. It is the one that leaves you with the most money when you actually need it.
A second wrinkle: Last shot at an RRSP
But just one more wrinkle for low-income seniors before we go. There are always wrinkles and few policies are clear cut.
Since any senior age 65-71 can contribute to an RRSP if they have the room, they can still contribute to an RRSP between 65 and 71 if they have ‘RRSP room’ and ironically, this is the only time when GIS recipients should be contributing to an RRSP.
Since the RRSP provides a deduction, it lowers your income. So, if you are in the GIS income range or just outside it, the RRSP contribution will lower your income but will also increase your GIS entitlement. It’s like the RRSP hydraulic in reverse.
At age 71 when retirement planning becomes much more limited, the strategies noted will result in you having a modest RRIF and hopefully a much larger TFSA. And when the inevitable financial shock arrives, you can use the tax-free TFSA money to pay for it.
Afterword
“When the clock strikes midnight, the fairy godmother’s magic expires and the carriage reverts back to a humble pumpkin. Depending on the version of the story, this chaotic reversion leaves Cinderella stranded or results in the carriage getting crushed and destroyed by palace horses.” (Google AI Overview)
Just like the Cinderella story, the RRSP/RRIF/TFSA story has many endings. Retirement income folklore easily rivals its more riveting predecessors but the best outcomes hopefully are better than in most of the many versions of Cinderella.