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How to minimize taxes and maximize cash flow in retirement

By: DAVID ISRAELSON

Date: September 30, 2015


Benjamin Franklin said that “nothing is certain, except death and taxes,” but as long as we are here, there’s a lot we can do about the latter, says Jennifer Poon.

Minimizing taxes and maximizing cash flow can be especially important for retirees or people nearing retirement, says Ms. Poon, Director, Advanced Planning – Wealth at Sun Life Financial Canada. While there are many ways to minimize taxes, the best place to start is by understanding how you are taxed, she says.

“How you earn your income – pension income, interest, dividends, capital gains, etc. –can have a significant influence on the amount of tax you pay, the government pensions you’re entitled to or the type of tax credits you get,” says Ms. Poon, whose specialty is tax-related retirement planning. “A lot of people look for niches, or go to seminars to look for anything that would give them an edge. I would start with the simplest thing — understanding what’s on your tax return.”

An investor’s tax bracket can have a big impact on which method of investment is more tax efficient. “For the lower [tax] brackets, dividend income is more advantageous,” she explains, because it offers the benefit of dividend tax credits as compared to income that is subject to full inclusion on the tax return. However, retirees who also receive Old Age Security (OAS) from the government should be aware that it’s the “grossed-up” dividend amount that is used for the clawback test.

“In the highest bracket, across Canada, capital gains income is most advantageous,” adds Ms. Poon, but this too should be balanced against potential clawbacks of OAS and other benefits. “These clawbacks could apply if you receive other benefits, such as those from provincial drug benefit programs [for seniors] or disability benefits.”

Andrea Thompson, a senior financial planner at Coleman Wealth in Toronto, agrees that it is important to achieve the right balance between all potential income sources during retirement. “Retirees should look for investments that pay stable and increasing dividends during retirement,” she says.

"This will give them the ability to keep up with the rising costs of lifestyle during retirement. Also, Canadian dividends earned in non-registered accounts qualify for the dividend tax credit, which creates tax-preferred income.”

It’s important to work with an advisor on tax planning and to find the balance between registered and non-registered income because “both private and government pension income is 100 per cent taxable,” Ms. Thompson adds. The same is true for income from Registered Retirement Income Funds (RRIFs). Canadians must convert any Registered Retirement Savings Plans (RRSPs) to RRIFs in the year they turn 71.

Ms. Poon notes that investment advisors have traditionally recommended “the 4 per cent rule” — withdrawing 4 per cent of total funds each year in order to sustain a 30-year retirement. But she recognizes that this strategy can get complicated in a volatile economy.

“Generally speaking, I do believe that 4 to 5 per cent is a sustainable withdrawal rate, but I would never use it as a hard and fast rule,” she says. “I agree with it from an academic perspective, but from a practical one, people should look at needs.”

Ms. Poon has worked on research about the rule and found that “there are a lot of assumptions that drive results, such as assumptions about the market,” she explains. “You have to consider whether the market going forward is going to act the same way as it has in the past.”

Going back to the Great Recession of 2008, says Ms. Poon, “we’ve had some unusual markets,” and it may be unreasonable to expect the same sequence of returns.

Another point often missed is the impact of tax rates, which can be different for 4 per cent of income depending on the size of the withdrawal. “For example, 4 per cent of $100,000 versus 4 per cent of $1-million can have a significantly different tax impact,” Ms. Poon says.

“Lastly, the 4 per cent rule doesn’t necessarily budget for unexpected expenses. These could be happy occasions — say, paying for your daughter’s wedding — or they could be things like unforeseen medical costs or helping out family. It’s becoming more common for families to help their adult children financially, for example,” she adds.

Retirees and those approaching retirement are naturally anxious about today’s volatile economy. “I tell people, control the factors that you can control,” says Ms. Poon.

“By this I mean: I can’t control interest rates, but I can control how I invest and how I receive the income. By managing my taxes, I can get the same amount of cash flow but perhaps with a different type of investment.”

As an example, Ms. Poon presents this scenario: “If I’m in the highest marginal bracket, I need a 12 per cent return to get 6 per cent after tax. But if I minimize the taxes I pay, I can get closer to 6 per cent pre-tax. That opens me up to different types of investment vehicles,” she says.

With today’s economic uncertainties, many clients are looking for lower risk investments such as guaranteed investment certificates (GICs), which also come with the downside of bringing lower returns, says Ms. Poon. Better tax management can help investors keep more of their returns while taking less risk with their investments.

“Perhaps we can save them some taxes and get them to the same point with their return, and they’ll sleep a little better,” she says.

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