March 11, 2015

How much have you really saved for retirement?

By Dave Dineen

You’ve saved for years and accumulated a nice retirement nest egg. But what are your savings really going to be worth, after tax?

Before you turn off the employment highway, make sure there’s nothing lurking in your financial blind spot. And by that, I mean taxes. When many people begin to transition into retirement, they’re amazed at how differently their various savings, investments and retirement plans are taxed. These differences can add up to hundreds of thousands of dollars, so you can’t afford to be blindsided by unforeseen taxes.

To give you an idea of the potential impact of taxes, here’s what could happen to $50,000 in different kinds of accounts:

Tax-free savings account (TFSA)

There’s no income tax payable on withdrawals. Because you contributed to your TFSA with after-tax dollars and the government doesn’t tax growth within your account, the entire $50,000 is yours.

If you hold any U.S. stocks that pay dividends in your TFSA, however, you may have to pay some tax. Under American law, dividends on U.S. stocks held by foreign investors are subject to 15% withholding tax, deducted automatically at source. (This isn’t the case for such dividend income within RRSPs and RRIFs, where a tax treaty between the U.S. and Canada applies.)

Registered retirement savings plan (RRSP)

RRSP contributions are deducted from your taxable income, reducing the tax you pay, but withdrawals are subject to income tax. How much tax you pay will depend on your income in the year you withdraw the money, and where you live in Canada. That could be as high as 50% (currently the highest rate in Canada). You may be paying less tax in retirement since your income is likely to drop once you stop working, but you could easily be looking at a tax bill somewhere between 25% and 30%. (See Canadian income tax rates for Individuals - current and previous years.)

Registered retirement income funds (RRIFs), life income funds (LIFs) and locked-in retirement accounts (LIRAs)

Rather than pay all the income tax due on the contents of your RRSP or LIRA when you close it down, rolling that money into a RRIF or LIF lets you take your savings out gradually (subject to annual minimum — for RRIFs — and maximum — for LIFs — withdrawal requirements), and thus pay the tax gradually. As in an RRSP, the investment growth within a RRIF, LIF or LIRA isn’t taxable until you withdraw it from the fund, but then it’s fully taxable at your marginal rate as part of the total amount withdrawn.

Non-registered investments

Examples: savings accounts, stocks and mutual funds in non-registered accounts and income properties. Because you’ve already paid income tax on the money you used to buy these investments, you don’t have to pay tax on it again. But the investment growth within the account is taxed:

  • Interest income from sources such as savings accounts, bonds or guaranteed investment certificates is fully taxable at your marginal rate.
  • Eligible dividend income from shares in Canadian companies may earn you a tax credit, which would lower the tax you pay on such income.
  • 50% of capital gains income from selling non-registered investments for more than you paid for them is taxable at your marginal rate in the year of sale. You can carry capital losses back up to three years and forward indefinitely to offset capital gains and thus reduce the capital gains tax payable. In most mutual funds, you create a capital gain when you switch between funds, by selling one fund before buying another. With “corporate class” mutual funds, however, you are switching between funds within a single mutual fund company – and that isn’t taxable. You will pay tax on the capital gain when you take money out.

See what I mean? I’m not exaggerating when I say that not being familiar with how your investments are taxed can be a dangerous blind spot. For example, if you don’t keep in mind that the size of your investment portfolio and your investment returns are reported in pre-tax dollars, you may find that your nest egg after taxes is smaller than you think. Additionally, not having a handle on investment taxes could cause you to miss out on valuable tax breaks.

It’s also important to know how your investments are taxed when you’re working out how much you can withdraw each year from your retirement nest egg without running out of money prematurely. If you follow the common guideline that says you can safely take out 4% of your savings each year, remember that it assumes pre-tax dollars. You’ll actually have less in your hand after tax.

So it’s a good idea to check your retirement blind spot today by booking a meeting with an accountant and financial advisor to assess your own specific situation.

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