Are you tax planning for you, or your estate?

“In this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin

While death and taxes may be certain, the variables in and around them are certainly not. That’s why they warrant attention and planning. The following analysis provides some food for thought when deciding whether to use proactive tax planning to optimize your living net-worth or your after-tax estate.

A tisket, a tasket, a future tax basket

Most retirees have baskets of “future tax” that are just sitting there in abeyance. The most common of these tax baskets is the one that’s attached to RRSP accounts. When you contribute to your RRSP, you get a tax deduction which gives you a break on the taxes payable in that year. But when the time eventually comes to make a withdrawal, each dollar you remove from your RRSP will be fully taxable and increase your income accordingly. 

Depending on the situation, there could be several other future tax baskets as well. For example, you might have unrealized capital gains that are attached to a non-registered investment account, or even an additional property. When these assets are sold in the future, the capital gain at that time will be subject to taxation.

Our tax system is progressive, which means the tax rates continue to increase as your income does, thus moving you from a lower tax bracket to a higher one. When you die (without a surviving spouse), all of the remaining tax baskets are dealt with at that time. This often results in a significant amount of taxable income that’s exposed to the highest marginal tax rates which can exceed 50%, depending on your province of residency.

Managing future tax

What can be done to manage this future tax in a way that avoids exposure to such high tax rates? One popular approach is to look at your projected retirement income and identify when in the future there might be years where income is lower than average or higher than average, and then try and shift income away from the high years to fill in the low years. This “tax averaging” often results in an acceleration of income in earlier years, which then lowers the exposure to high tax rates later in life or upon death. 

If you think this sounds challenging, remember that any financial planner worth their salt should be able to review your assets and liabilities, then map out your projected income going forward on a year-by-year basis. The low-income years most commonly occur immediately following retirement; the paycheque has stopped, but maybe you have ample cash and non-registered savings that can be used to fund your lifestyle. It’s quite possible that the income you would report on your tax return in these years would be minimal. However, by the end of the year that you turn 71 your RRSP accounts must be converted into RRIF accounts, giving rise to forced annual withdrawals that are fully taxable. These mandatory withdrawals might mark the beginning of your high-income retirement years and may even result in your Old Age Security (OAS) being clawed back. That being said, it really depends on one’s individual circumstances. 

The nice thing about the future tax is that, for the most part, you have flexibility in deciding when you convert that future tax into current tax. Just because you can wait until age 72, when you are forced to make your first withdrawal from your RRSP (RRIF), doesn’t mean that you must wait until you are 72. Furthermore, this doesn’t need to be a cash flow decision. If you don’t need the money to fund your lifestyle, then you can simply take the money that is withdrawn from the RRSP and then (subject to withholding taxes) reinvest it back into another account such as your TFSA or non-registered account. The point here is that you have the option of choosing what you believe to be an optimal year to increase the amount of income that will be reported on your tax return.

Similarly, you can choose to trigger a capital gain within a non-registered account at any time. A sale of a stock doesn’t need to be an investment decision – it can be a tax decision. Simply sell the stock, thereby triggering the capital gain, and then immediately rebuy it. The capital gain will then be reported on your tax return in the year it was sold, and your taxable income will be increased accordingly.

In a nutshell, every dollar of income that you accelerate is a dollar of income that you don’t have to report in the future, and you get to choose what tax rates get applied to that dollar; the current marginal rate, or the future marginal rate (which could be higher). It’s easy to see how this process can result in your paying a lower average lifetime tax rate.

How to impact your lifetime assets and estate

Let’s dig a bit deeper. How do these choices carry forward and impact your lifetime assets and ultimately your estate? I’ll begin with some foundational ideas and then provide a real-life example.

Imagine a scenario where your current marginal tax rate is 30% while living, but if you died then the marginal tax rate on your final tax return would be 50%. 

Now let’s assume that you proactively make a withdrawal of $10,000 from your RRSP. This $10,000 would hit your tax return and you would pay $3,000 of tax. 

If you were to die the following year, your decision to have made the early RRSP withdrawal would have saved your estate $2,000. This is due to the differential in the tax rate that you paid on the withdrawal compared to the tax rate that would have otherwise been paid on your final tax return (30% vs. 50% = 20% savings).

However, if you remained living for some time then you would have lost your ability to earn any additional investment income on the $3,000 that was paid to the CRA. Make no mistake, the decision to make an early RRSP withdrawal has resulted in the prepayment of tax and it will reduce your living net-worth. The tradeoff is that you’ve also likely increased your after-tax estate. So what’s the opportunity cost? If left untouched for 25 years, that $3,000 would have had the opportunity to grow to over $10,000 if it earned a rate of return of 5% inside the RRSP.

So you need to ask yourself, is your goal to increase your living net-worth or your after-tax estate (dying) net-worth? You also need to estimate your investment rate of return and your life expectancy. If you have a spouse then their life expectancy is also an important factor (more on this later).

I’ve reviewed this scenario in detail for many of my clients and while the short-term results often make very clear logical sense (as mapped out above), the longer-term findings can sometimes be a bit surprising. There can come a point in the future when, eventually, the compounding effect of having a larger portfolio more than compensates for the tax differentials, so that both the living net-worth values and the after-tax estate values are lower due to having accelerated income earlier in life than necessary via RRSP/RRIF withdrawals. To put it another way, if you live long enough then the investment dollars that you’d retain by not subjecting them to early (low) tax rates would eventually grow to be such a size that your estate would still be higher on an after-tax basis, even if your estate was subject to top marginal tax rates.

The following scenario demonstrates how this could work:

A married couple has a single RRIF with an approximate value of $1.5 Million. That’s their only retirement account. There are no non-registered savings and no TFSA accounts. The RRIF holder’s age is 65, so the RRIF withdrawals qualify for income splitting. They each have OAS and partial (but not maximum) CPP payments, and a home that’s paid for. Until now, they’d been withdrawing $6,900/month gross from the RRIF account to fund their lifestyle needs.

Let’s consider two alternative projections:

When we compare their living and dying net-worth in their current drawdown scenario (Plan A) and the RRIF meltdown scenario (Plan B), the early results were as expected. Accelerated drawdowns of their RRIF resulted in paying more tax earlier than necessary, therefore, living net-worth was decreased. Also as expected, paying tax while alive at lower rates meant that on a year-by-year basis, their combined after-tax estate was enhanced as a result of the early withdrawals. Remember, upon death they would be exposed to 50%+ tax rates on the majority of the RRIF balance.

However, at age 85 there was a turning point which occurred. Before that age, the accelerated withdrawals had always resulted in a higher estate being left to their children, but after 85 their estate was actually reduced. The compounding effect of having a larger portfolio left intact (Plan A) more than compensated for the higher tax rates which that portfolio would be exposed to on their death. The turning point in this projection occurred at age 85, but your scenario may very well be different.

If you prefer to plan around longevity, you might look at these results and conclude that tax averaging is not for you. But, perhaps there’s some prudence in exploring a part-way solution. The couple above could draw out more from their RRIF than what is required to fund their lifestyle, but they don’t need to go as high as $10,000 per month. The excess withdrawals could still be funneled into TFSA accounts, which would provide them with considerable flexibility going forward. Life doesn’t always play out as expected and large expenses can occur without notice. Having some money tucked away inside TFSA accounts would provide them with a source of easily accessible, tax-free funds that they could use to fund large (unforeseen) expenses. Without this foresight and planning, these expenses would need to be funded from their RRIF, which would lead to spikes in taxable income and a potential claw back of their OAS.

Furthermore, the above analysis makes the optimistic assumption that both spouses remain alive throughout the entire timeline. However, if one of them were to pass away early, the tax situation for the survivor would completely change. Moving from two taxpayers to one would result in higher marginal tax rates being paid by the surviving spouse during their remaining lifespan. An early death of even one spouse adds an advantage to Plan B.

Hopefully, this has given you some insights on how you can reframe your options, and potentially minimize the tax hit on your living and dying net-worth. It never hurts to run the numbers and have a rational conversation about how life might unfold under a couple of alternative scenarios. Understanding what impact the decisions you make today can have on your future can help reassure you that you’re doing what makes the most sense for you over time. And remember, there can be some wisdom in not going all-in on a given strategy. Sometimes, a more reasonable approach is to hedge your bets and go half way.