Registered Retirement Savings Plans represent 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 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 withdrawing 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.
That being said, you could convert RRSPs to income as early as age 18, but should wait until later in your life.
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 most 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.
What are my income 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. There are lots of other reasons why the RRIFs are attractive.
- Life Annuity. Think about a pension plan and that will help you to understand what an annuity is. Just like a pension plan, an annuity is simply a tool that provides you with a fixed stream of income that is guaranteed for the rest of your life. Regardless of markets, interest rates, inflation or the economy, your cashflow remains stable and fixed for your lifetime. There are also reasons why annuities make sense.
- 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.
How do you know which 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.