The days of working for a company for 30 years and having them take care of you in retirement are long gone. A life-long pension was the reward for a loyal employee who dedicated their career to one employer. Things have changed. Very few employees stay with one company for their entire careers.
By the same token, very few companies offer their employees a lifelong pension. In many cases, Canadians assume the responsibility of ensuring they have sufficient income sources in retirement.
So, what would make up your sources of income in retirement? Canadians have the opportunity to benefit from one or more of the following list:
- Government Benefits (i.e. Canada Pension Plan, Old Age Security, Guaranteed Income Supplement, Allowance, etc.)
- Employer-sponsored Pension Plan (Defined Benefit Pension Plans, Defined Contribution Pension Plan, etc.)
- Registered Investment Plans (Registered Retirement Savings Plans, RRIF, LIRA, LIF, TFSA, etc.)
- Investment Income (i.e. dividends, interest, capital gains, rents, etc.)
Each of these forms of income plays an important role in your retirement. The main priority is to have enough income from all sources to allow you to do the things you want to do while retired.
The first and most important step in planning your retirement income is understanding how much income you need to satisfy your required living expenses. This “number” will help you determine how and when you gain access to the different sources of income. Remember, your living expense amount is after-tax whereas your retirement income sources are before-tax. Therefore, understanding how each source of income is taxed will help in planning your income.
- The following Government Benefits are all taxed as regular income at your current marginal tax rate:
- The following Government Benefits are non-taxable income:
- Registered Pension Plan withdrawals are all taxable income at your current marginal tax rate:
- Defined Benefit Pension Plan (paid in regular installments)
- Defined Contribution Pension Plan (paid in lump sum withdrawals or in regular installments once converted into a registered income plan)
- Registered Investment Plan withdrawals are all taxable income at your current marginal tax rate:
- RRSP/LIRA withdrawals
- RRIF/LIF annual minimum payments
- Different forms of investment income are taxed in their own unique way.
- Capital Gains (50% are taxed at your current marginal tax rate)
- Dividends (preferential tax treatment depending on the type of dividend – Canadian eligible, Canadian ineligible, foreign, etc.)
- Interest (100% is taxed at your current marginal tax rate)
- Rents, after expenses (taxed at your current marginal tax rate)
- Annuities (tax treatment is dependent on the source of funds to purchase)
- Annuities purchased with registered funds pay income that is 100% taxable at your current marginal tax rate
- Annuities purchased with non-registered funds pay income where only the interest income is taxable. 100% of the interest is taxable at your current marginal tax rate
I’ve talked a lot about “current marginal tax rates”, but what does that even mean?
By definition, the marginal tax rate is the tax rate applied to the next dollar of taxable income. These rates get increasingly higher as your taxable income increases. Currently, the top marginal tax rate is 53.53%.
Contact a professional advisor for effective tax planning and strategies.
To really understand how your retirement income is taxed, let’s walk through a simple scenario:
- All sources of income are calculated to arrive at Total Income. We’ve already talked about sources of retirement income above.
- Reduce the total income by using allowable deductions. Some examples of allowable deductions are: RRSP contributions, carrying charges, child-care expenses, net capital losses, non-capital losses, etc. There are two levels of deductions on the T1 to arrive at the taxable income (Total income to Net income; Net income to Taxable income).
- Income taxes payable are calculated on your Taxable Income using graduated rates. A graduated rate system ensures that you pay a higher rate of tax on additional income earned. For example, if you have a taxable income of $100,000, then your maximum taxes payable are just under $23,000. This amount is considered your balance owing.
What is a balance owing?
Most Canadians will not have a significant balance owing because portions of the income tax payable are paid up-front throughout the year in the form of withholding tax. Some examples of withholding tax are: taxes taken at source from your employment income, taxes taken at source from your CPP or OAS benefits, taxes taken at source from an RRSP or RRIF withdrawal, etc.
The difference between what you paid up-front in “withholding tax” and the actual “taxes payable” (calculated on your taxable income) is your “balance owing”.
You may also be in a position where you don’t have a balance owing, but instead a “refund”.
What is a refund?
Simply put, a refund is a result of paying more income tax up-front, than what is due after calculating your taxes payable on your taxable income. In other words, the CRA is paying you back for the excess income tax you paid to them up-front.
I often hear Canadians talk about how unfortunate they are for having a large balance owing, or how “great their accountant is” due to how large a refund they received. Neither is a good or bad thing. It is simply “is what it is”. If you have a large refund, you have paid a large amount of your income tax upfront and are now being paid back the excess after having calculated how much you actually owe.
It could be the case where your tax professional (i.e. accountant, financial advisor, etc.) has been able to reduce your taxable income even further through strategic deductions, applying for specific credits, or implementing income splitting strategies to reduce the household tax bill, but the concept of paying a lot of income tax upfront is normally the reason.
Conversely, a large balance owing means you have not paid much income tax upfront, and must now pay the commensurate amount of income tax given your taxable income. That said, the optimist sees this scenario as having use of your money throughout the year instead of the CRA.
Income tax in retirement does not have to be scary or complex. If you understand the basic rules and concepts around income and how it is taxed, you will never be shocked or surprised by the results of your tax return.
Alternatively, seek out a financial professional for retirement planning services to ensure that you are taking advantage of all benefits afforded to you in order to reduce your taxable income or ultimately, your income taxes payable.