What is your retirement sweet spot?
The retirement sweet spot is a term I use to describe the optimal tax efficient income in retirement. The sweet spot is based on your retirement price tag or how much your annual lifestyle will cost you when you retire? If your price tag is too high, then it is difficult to create optimal tax efficiency. Tax efficient income is created through planning around the marginal tax brackets.
Here are a couple of examples of the Retirement Sweet Spot at work:
Alison retires with a pension
Alison is single and works for the government. She has a defined benefit pension that is going to pay her $3200 per month at 63 when she is retires. She will also qualify for $522 per month of early Canada Pension Plan (CPP). At 65, she will also get Old Age Security of approximately $546 per month. If we add up her 3 pensions, she will get about $4268 per month or $51,216 per year. After tax, she will get about $3300 per month net (Based on Alberta tax rates). Since Alison will exceed the lowest tax bracket of $43,561, her sweet spot will be achieved if she keeps her income under $70,954 which happens to be the starting threshold for Old Age Security (OAS) clawback or recovery. Alison could earn another $19,738 before losing some of her OAS after age 65. After that, retirement gets more expensive. For Alison, she stays in her income sweet spot if she is able to live off of $3300/month to as high as $4400 per month.
Ideally the retirement sweet spot occurs if you can keep your taxable income in the lowest tax bracket. If a single person can live off about $2900 per month in retirement, they would keep their gross income under $43,561 which is the cut-off for the lowest marginal tax bracket. If someone needed more, they could supplement with non-taxable sources like Tax Free Savings Accounts or non-RRSP savings. If they were like Alison where there income would be higher or they simply had a higher price tag, the next threshold is the starting OAS clawback amount.
A retired couple can split income
Jean and Mark live in Alberta and they are about to retire within the next couple of years. Jean has a pension from work while Mark is self-employed. Their biggest question is whether they have saved enough to retire comfortably. Again, the answer really lies in understanding their retirement price tag. They figure, their price tag will be about $5000 per month after tax. The good news is this price tag means they are likely to retire within the sweet spot where they can keep both their incomes in the lowest marginal tax bracket (under $43,561 of income per person). Once their lifestyle price tag exceeds about $5500 per month, it’s not terrible, it just gets more expensive because of a higher marginal tax rate.
Income splitting makes a difference
Couples have a bit of an advantage in retirement because of the ability to split income. For example, a single person making $80,000 will pay about $20,400 in tax. That’s considerably more than a couple with each spouse making $40,000. Each spouse would only pay $7875 for a total combined tax bill of $15,750. That’s a 23% savings in tax. In both cases, the household brings in the same total gross income but the total tax varies dramatically.
If couples can live on $5500 per month net or less in retirement then they will hit their tax efficient sweet spot. Singles need to live on half of that to stay in the lowest marginal tax bracket.
At a $5000 per month retirement price tag, Jean and Mark need to generate about $70,000 per year of combined gross income. Jean’s pension, CPP and OAS will give her about $48,000 per year which means Mark will need to generate about $22,000 per year from his RRSPs. These figures are based on the math that they will each report $35,000 of income through income splitting strategies like pension splitting and CPP splitting. $35,000 of gross income will create about $2400 per month net income each.
Planning is personal
The retirement sweet spot is another general rule of thumb. It forms a good benchmark for income planning but the best planning looks at many other things. For example, I would never encourage people to cut back on their spending just to keep their taxable income under $43,561 especially if that means they will eventually have too much RRSPs when they are older and can’t spend it. Or even worse, if it meant they would die with too much RRSPs. As much as tax efficient retirement income planning is important, it is not the only factor that drives financial decisions in retirement.
(All examples are based on real people living in Alberta. Residents of other provinces will have slightly different tax rates.)DOWNLOAD 2013 TAX RATE CARD