RRSP conversion options: How to convert your RRSP to income?
Registered Retirement Savings Plans (RRSPs) are one of the most significant retirement planning tools for Canadians. There are a number of ways to put your RRSP money to work during retirement, but they all boil down to a simple concept. The money you accumulated during your years of saving and investing is converted to a vehicle that provides you with a stream of retirement income. Instead of making contributions, you will rely on withdrawals from your nest egg to subsidize your retirement expenses. Instead of saving money it’s time to spend it!
When is the best time to convert your RRSP into income?
The best time to convert your RRSP into income is when you need to. Typically, this occurs when you retire and have no paycheques from work. The ideal situation is to contribute to an RRSP in your ‘earning years’ when you are paying taxes in a higher marginal tax rate and then withdraw the money later when you have no other sources of income (like in retirement). Taking income from the RRSP while you are still working can be very costly and will negate the benefits you derived from contributing in the first place.
Sometimes developing a withdrawal strategy for your RRSPs has less to do with the need to spend it. For example, some people are motivated by tax strategies like taking advantage of the Pension income tax credit, or minimizing OAS clawbacks, or withdrawing RRSPs at lower tax rates. Sometimes, deferral of RRSP income can actually be a problem.
Related article: Developing RRSP withdrawal strategies
How long can you defer the RRSPs?
Many pundits will advise that you should defer your RRSPs for as long as you possibly can. While this may be true in many circumstances, it is a rule of thumb and does not apply in all circumstances. Most people defer the decision to convert RRSP into income so they can defer the tax. Canadians hate to pay taxes so much that they avoid any withdrawals from the RRSP until they are forced to do so. Sometimes deferral can be the costly alternative. Government rules stipulate that you must wind up your RRSP by the end of the year in which you turn 71.
Basically, you must convert your RRSP into a Registered Retirement Income Fund (RRIF) or life annuity in the year you turn 71, but you do not have to start that income in the year you turn 71. It must start in the following year.
If you turn 71 this year and you have not converted your RRSP into an income vehicle, you need to see your financial advisor or financial institution before December 31.
Related article: 5 reasons not to defer RRSP income
What are my RRSP conversion options?
Today, most people will convert the RRSP into a RRIF, but this is not the only option you have available to you. In fact you, have four alternatives:
- Cash out the RRSP. While this may be an option, it is not usually a good one. Cashing out means that the full value of your RRSP is added to your income and taxed accordingly. Unless you have a very small amount, this can mean a significant part of your wealth will go to the government. Remember that when you cash out the RRSPs withholding tax is applied but the total tax owed is based on your marginal tax rate.
- Registered Retirement Income Fund (RRIF). Most Canadians select RRIFs as their retirement income option. The current flexibility of RRIFs has made them extremely attractive. The RRIF is by far the most popular income option for RRSPs. It is flexible in many aspects. You can select the investments, income frequency, and amount of income. You can also make changes to all of these aspects in the future.
Related article: Everything you need to know about RRIFs
- Life Annuity. A life annuity is really another word for a pension. In the conversion to a life annuity, you simply give your money to a life insurance company. In turn, they pay you a fixed stream of income that is guaranteed for the rest of your life. Once you pass away, your income stops. There are many variations of annuities (joint, guarantee periods, reduction factors, indexing).
Related article: Everything you need to know about Life Annuities
- Fixed Term Annuity. Unlike the life annuity, the fixed term annuity does not pay you an income for a lifetime. Instead, you choose a fixed term like 5, 10, 20 years, etc. The only stipulation is the term cannot extend past the age of 90.
Options for pension money are a little different
For anyone who has left an employer offering a pension plan prior to retirement, chances are you have moved your pension money into a Locked-in Retirement Account (LIRA). A LIRA is similar to an RRSP except that it contains money that has been deposited through a pension. There are different rules when it comes to converting pension money into income.
Related article: Differences between a LIRA and a RRSP
Firstly, there is no option to cash out pension money. Pension money is always designed to provide lifetime income. Legislators were concerned that retirement plans could be taken out prior to retirement and exhausted before your death.
- Life Annuity– In the past, the life annuity was the only option for pension money. In the early 90’s, legislators developed some options to deal with Canadians who were not staying with the same employer for their working career. You still have the option of selecting a life annuity.
- Life Income Fund (LIF)– The LIF is very similar to a RRIF. You have the flexibility of choosing your investments, your income frequency and your income level. The only difference is that there is an imposed maximum income that you can withdraw each year. The maximum income is based on a factor known as the CANSIM rate. The LIF must eventually be converted to a Life Annuity (age 80). LIF rules differ from province to province so check the pension legislation for your area for more detailed information.
Related article: Retiring with Pension money and Unlocking rules
How do you know which RRSP Conversion Option is best for you?
The easiest answer is good planning. Different people will have unique circumstances and needs. These issues will determine which option(s) is best suited for you.
Remember that it is not an all or nothing situation where picking one of the options means you cannot choose other options. Sometimes a combination may be the ideal solution.
I can offer some important considerations when comparing RRIFs to annuities.
- Flexibility of income or investment choice– If you are looking for flexibility to set up the income the way you want, with the option of making changes in the future, the RRIF winds hands down. On the other hand, flexibility and choice can be a curse for some who prefer to keep it simple and secure. In these cases, an annuity might make more sense.
- Control– Some people want control, while other just want to be able to set something up and let it run on autopilot. Annuities have the distinct advantage of being easy to set up and understand. RRIFs require more decisions and more management.
- Estate preservation– Generally, the best alternative to provide an estate benefit is usually through the RRIF. You can provide an estate with life annuities if it is set up with proper guarantee periods, but these options can reduce your level of income.
- Spousal protection– Providing survivorship options for your spouse can be facilitated under any route you choose (RRIFs or annuities). However, in the case of annuities, you must make sure they are set up properly.
- Lifetime income – If you are looking for income that will be guaranteed to last a lifetime, there is no better choice than the annuity. Those who are concerned about longevity often like the idea of life annuities that provide lifetime income.
Converting RRSP to income examples
Converting RRSPs to income can be a very complex decision. I must re-emphasize that everyone’s situation is unique and different and generalizations can be very dangerous. Let’s take a look at some examples but be very careful before applying strategies to your personal situation. You should seek the help of a financial advisor or purchase good software programs to help you through the maze of creating income in retirement.
Income flow possibilities
Many readers asked me to provide examples of income flow differences between the annuities and the RRIFs. In the following chart you will see a comparison of some income flows for a $100,000 RRSP for a 65 year old male and female.
|Age||Single Life Annuity (Male)||Joint Life Annuity (100% survior)||Annuity to Age 90||Minimum RRIF||Level RRIF|
If we are looking at income and income alone, the Single Life annuity provides the highest immediate income. This income is guaranteed for the life of the annuitant no matter what happens to interest rates, markets or the economy. Assuris guarantees life annuities up to $2,000 per month of income per Life Insurance Company.
The disadvantages to the life annuity are the inability to make future changes and the loss of any use of the capital. Once annuities are set up with registered funds they are pretty much set up for life.
Looking at these numbers, it is easy to see why most people are choosing RRIFs over annuities today. Take these numbers and add the fact that you retain control over your future income, investment options and decisions of capital and you have a pretty compelling reason why RRIFs are so popular. The only people who tend to choose annuities today are ultra-conservative investors who want a hassle-free approach to income.
Which option is best for you?
To make the right decision, you will need to run some projections so you can compare the income levels from the different income options.
If you are looking for guaranteed lifetime income the life annuity is likely to be your best bet. The major problem with annuities today is interest rates are so low. When you buy an annuity, you are really locking into current interest rates for the rest of your life. When it comes to buying an annuity, you should shop annuities with different insurance companies because annuity rates can vary drastically from one carrier to another. Once an annuity is set up, it is set up for life. There are no provisions for flexibility and change. You must also be aware of the survivorship issues if you are considering life annuities.
If you are looking for more flexibility, RRIF is by fare the more popular choice. With a RRIF, you have flexibility over income, investments, frequency, etc. You also have the flexibility and control to move from a RRIF to an annuity in the future. You might elect to use a RRIF until interest rates go up at which time to can lock into higher rates with a Life Annuity.
Related article: Differences between RRIFs and Annuities
You can look at this from a number of different perspectives:
If you feel that you can earn a 5.25% investment return on the RRIF, you can create an equivalent income stream to the single life annuity ($524.50 per month) and protect your capital. In other words, if you feel you can manage a RRIF to earn greater than 5% over time, you are likely to consider the RRIF.
A balanced portfolio of bonds and equities has returned an excess of 5% over the last decade but there can be significant short-term fluctuations from time to time. Nobody can guarantee returns in the future so you and/or your financial advisor must determine if that figure is realistic.
If you are more conservative on your assumptions and think a 3% or 4% return on the RRIF is more realistic but would like an income of $509.76 per month (equivalent to the Life Annuity), you can do it with the RRIF. Afterall, you can set any income amount you want as long as it meets the minimum income requirement. However, setting the income level too high means the capital will exhaust over time. In this example, the capital would exhaust at age 88. Another way to look at it might be, if you know your date of death, your decision would be a lot easier.
As mentioned in the previous article, comparing income is simply one aspect of choosing the right income option. “Providing survivorship options for your spouse can be facilitated under any route you choose — RRIFs or annuities. In the case of annuities, however, you must make sure they are set up properly.
In the annuity, you are guaranteed to have no survivorship unless you choose the joint life option or the term to age 90.
Most people will take the RRIF but there was one case I ran across where the annuity was chosen on the basis that the surviving spouse was not inclined to manage money and only wanted to have a fixed income in her bank account. The Joint Life Annuity was chosen without a reduction on the basis of easy management for the spouse should something happen to the primary annuitant. This example further emphasizes the fact that everyone has unique circumstances and while the RRIF appears to be the most popular vehicle of choice for income for registered funds, it will not always be the right choice.
Words of caution
The data in this chart was updated in 2023. The chart used here represents a male age 65 in average health. The investment return on the RRIF is 3%. Many variables can change the numbers provided in the chart above. A change in age, health, interest rates, guarantee periods, reduction factors, investment options can alter the numbers dramatically. Use this information with caution and skepticism. If you are converting your RRSP into income, ask a financial advisor to provide numbers specific to your situation.