Tuesday, 11 August 2015

Financial Studies 1 - RRSP Withdrawal Strategies?

What is the question?

I have three questions I want to answer with this blog post. 
  1. Should you begin withdrawing RRSP when you retire, or wait until some later time such as at 71 when you are forced to begin withdrawals?
  2. What is the amount of withdrawal from RRSP, relative to withdrawals from other investment accounts, that will maximize value?
  3. Will you maximize value by setting income from RRSP to make your taxable income the top of a specific tax bracket?

Consider the following scenario. You decide that it is time to retire and you are now 60. You have investments in an RRSP and in a taxable investment account. You also have a little in a TFSA. At 65 you will begin to receive CPP and at 67, OAS.

Withdrawals from the different accounts have different tax implications, the RRSP grows tax free, but all withdrawals are taxable as income. The taxable investment account may have investments with very different tax implications such as interest income, eligible dividends and capital gains. Which account you withdraw from first may make a difference to your retirement. In addition there are other complications to this calculation such as claw back of OAS if your income exceeds a certain amount. 

It is a simple question, but given how complex our tax system is, the procedure to answer this is also complex.

We can answer this question using the retirement forecaster spreadsheet. The spreadsheet is a pretty accurate cash flow forecaster that handles all the necessary details to make a retirement cash flow forecast and also to answer questions such as this one. You can get a copy of the spreadsheet and read about the capabilities and details at this blog post - Retirement Planning and Forecasting 2.0.

Basics of The Retirement Spreadsheet

The inputs to the spreadsheet include your current financial situation and some assumptions for creating a forecast. The spreadsheet creates a cash flow forecast during employment and during retirement. During retirement, income is sourced from any pension plans you have, CPP and also OAS. Additional funds above this to meet your required expenses, which you specify, are sourced from your different investment accounts (RRSP, TFSA and Taxable Investment). An accurate tax model is used to ensure the effects of differing tax rates are included.

The results of the spreadsheet is a cash flow forecast for one or two people, showing where the retirement income is sourced from and how much tax is paid. The spreadsheet will report if the assets will last long enough for your life expectancy, and if so will also calculate an Estate Value, accounting for taxes payable on death.

When trying to determine the best scenario, I use the Estate Value as a measure of the success of the scenario. I use Estate Value rather than account balance as it takes into account the differing tax rates on money left in an RRSP vs a Taxable Investment account.

With the default settings in the spreadsheet model, cash required to meet expenses is withdrawn from the different accounts proportionally based on the current balance of these accounts. This tries to make the accounts empty at the same time. You can change the priority of the withdrawals by changing the "Account Withdrawal Weightings". If you increase this value above 1 for an account, then more will be withdrawn from that account in preference to other accounts. If you decrease the value below 1 then less is withdrawn. The ratio of amount withdrawn is approximately linear to the value. 

For example if you have $500k in RRSP and $500k in Taxable and need $50k of income, with the default settings of 1, then $25k will be withdrawn from each of the accounts (I'm ignoring taxes in this example - the retirement spreadsheet does not). If the Account Withdrawal Weighting for RRSP (RRSP Weight) is set to 0.5, then 16.7k will be withdrawn from the RRSP and 33.3k from the Taxable. 

You can use this feature to increase or decrease relative withdrawals from your RRSP account. To stop withdrawals from RRSP altogether, you can set the "Defer RRSP W/D to RRIF Age" to 1. This will stop all RRSP withdrawals until you convert it to a RRIF, the age of which is set by another input "RRIF Conversion Age", which must be 71 or less. 


Consider the following example. Current age of 60, retiring immediately, life expectancy of 85, no DB pension plan, CPP at 65, OAS at 67, RRIF conversion age at 71, $500k RRSP, $50k TFSA and $450k Taxable Investment, Expenses of $50k per year. The Spouse has the same settings. Any changes to settings are the same values for the spouse.

The inputs to the spreadsheet and the cash flow forecast are below. In the first year the income from both RRSP and the Taxable Investment account are $28k per year. After taxes net income is $50k per year. The Estate Value (EV) is $850k in current $.

Lets look at whether it is better to accelerate or defer RRSP withdrawals. 
To stop RRSP withdrawals until 71, set the "Defer RRSP W/D to RRIF Age" to 1 and the RRSP Weight" to 1. The resulting EV is $837k. That's lower so not a good idea. 

Change the "Defer RRSP ..." back to 0 and try different "RRSP Weights. For "RRSP Weight" = 0.5 the EV is $854k, for "RRSP Weight" = 1 the EV is $850k and for"RRSP Weight" = 2 the EV is $840k. 

The case with the most value is to withdraw RRSPs beginning immediately, but use an "RRSP Weight" of 0.5, which reduces the RRSP withdrawals, but not entirely. What you can also see from these results is that the differences are quite small. The difference between the best and worst case Estate Value is just $13,000, which is good money, but remember that the total expenses for this couple in their retirement is $2,500,000 (2 people x $50,000 per year x 25 years), so it is relatively small.

The cash flow forecast for the best case (RRSP weight = 0.5) is below. In the first year the income from RRSP is $18k and from the Taxable Investment account is $36k per year. After taxes net income is $50k per year. 

To answer the third question in my list we need to use another special feature in the retirement spreadsheet. Set the "Enable Added RRSP W/D to Tax Bkt" to 1, and set the "Tax bracket to top up to" to 1, which is the 15% federal tax bracket, or about $45k in 2015. Also set the RRSP Weight to 0.1. This will set the RRSP withdrawal low, but then the RRSP withdrawal will be increased so the taxable income is at the top of the 15% tax bracket. This case has an even higher Estate Value of $857k, but note that the difference is still small. This is a good strategy, but the increase in personal value for the effort is small. 

The cash flow forecast for this case is below. In the first year the income from RRSP is $23k and from the Taxable Investment account is $32k per year. After taxes net income is $50k per year. 

I performed a few more simulations with different initial values to see what difference it would make. The table below shows the results of these simulations and the Estate Values for each. 

Case A is the example described above, note that in this case 50% of the retirement assets are in the RRSP and both spouses life expectancy are 85.

Case B is the same as A except that one spouse dies at 80 and one at 90. The best case is the RRSP weight of 0.5 again (highlighted in green). Note the Estate Value is lower than case A, mainly due to some OAS clawback and higher taxes paid by the surviving spouse.

Case C and D are now with 1/3 of the total retirement assets in RRSP. 

Current Age6060606060606060
Retirement Age6060606060606060
Life Expectancy8580/908580/908580/908580/90
RRSP Balance ($k)500500330330500500500500
TFSA Balance ($k)5050505050505050
Taxable Balance ($k)45045062062095095014501450
Retirement Expenses ($k/yr)505050507575100100
Estate Value (Current $k)
- RRSP Off Until 71837665971807905590887434
- RRSP Weight = 0.5854683978814891588889447
- RRSP Weight = 1.0850678976812879570859407
- RRSP Weight = 2.0840660967796848534807354
- Top up to 15% tax bracket857686981817908604914475

Cases E and F raise the retirement assets and retirement income by 50% to $1.5 M each person and increases the retirement income by 50% also. This is to see if higher taxes changes the outcome. 

Cases G and H raise the retirement assets and retirement income even further. 

You can see from all these cases, that the strategey to only take enough RRSP income to top out your taxable income at the top of the 15% tax bracket is the best strategy. If you don't follow that strategy, you are not losing much and the next best strategy is to weight your withdrawals from RRSP downward so you take relatively less from the RRSP than your Taxable Investments (on a proportion of assets basis).  

In conclusion, the best case is to begin RRSP withdrawals at retirement, but maybe withdraw less from your RRSP than your Taxable investment account. If your taxable income is less than the maximum for the 15% tax bracket, you have the time and capability, then a strategy of withdrawing extra from RRSP to bring your taxable income up to the top of the 15% tax bracket.

If your situation is different than the example cases I have run, you or your accountant should do your own calculations to determine the best strategy. 

Disclaimer:  These posts are not fully comprehensive financial advice.  You should seek your own qualified investment, tax and legal advice.

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