The problem with RRIF withdrawals

March 14, 2022

RRIF_withdrawalsMillions of Canadians use Registered Retirement Savings Plan (RRSP) accounts to invest and save for retirement. Their appeal is simple, contributions to these accounts within the annual limit are tax-deductible. Income earned in the RRSP is also tax exempt, provided that income remains within the account. It’s a short-term tax incentive for making the important long-term decision to save for retirement.

But, when Canadian RRSP holders turn 71 those accounts turn into Registered Retirement Income Funds (RRIFs). As the name implies, an account designed for savings becomes a fund designed for income. When income is involved, tax must be paid.

How RRIFs are Taxed

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It’s important to begin by making a clear distinction: the tax benefits of RRSP savings should be seen more as a deferral than a rebate. Tax on the income saved in an RRSP will be paid once that RRSP converts to a RRIF and the holder is forced to make mandatory withdrawals.

RRIFs are subject to annual minimum withdrawal amounts set by the federal government. The money held in an RRSP has to be drawn upon at a rate that increases with the age of the holder. Investments like equities or ETFs held in an RRIF may have to be sold in order to make those minimum withdrawals.

Those minimum withdrawals are taxed as income and, in the case an individual need to withdraw more money from their account than the minimum, that will also be subjected to a 10%-30% withholding tax depending on the amount withdrawn. In Quebec that bracket is 20%-30%.

How RRIF withdrawals and taxes can hurt investments, legacy

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While the income provided by a RRIF is designed to help retirees live, it’s important to note that not every retiree has the same needs or goals and the government-mandated approach to withdrawals, plus the taxes paid on these withdrawals, can result in undue losses for a retiree, both in tax paid and potential capital appreciation missed.

If a retiree has to sell some of the securities they hold in their RRIF account to make their mandatory withdrawal amounts, they could lose out on some of the significant growth opportunities that those equities were still subject to. If the withdrawal comes at a time when the equity is down, too, that could result in realizing a significant loss on invested capital.

It’s important to consider, too, that many retirees today live longer lives, and may require expensive long-term care when they enter their late 80s and 90s. Taxed withdrawals, or the loss of capital appreciation opportunity in a retirees’ 70s could have painful ramifications for them and their families as they age.

The other key factor to consider is legacy. For many retirees and pre-retirees, an important use of those savings is as a legacy to leave their children or grandchildren. Many older Canadians want to leave enough for their children to make a down payment on a house or pay off student loans and mandated withdrawals stretching late into life can derail those goals.

How equity income can offset these downsides

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A key tool retirees could use to offset the mandatory withdrawals’ impact on their life savings was fixed income. By holding bonds and other income products in their RRIFs, retirees could withdraw the income they generated without having to sell appreciating or income-paying assets held in the account. Today, however, most fixed income products yield income at rates significantly below the mandatory withdrawal rate.

That’s where equity income can come in. At Harvest ETFs, our suite of equity income ETFs have proven their value to investors, and especially retired investors, by providing consistently high annualized income yields paid on a monthly basis. Our latest such product, the Harvest Diversified Monthly Income ETF (HIDF:TSX), sets a target yield of 8.5%. Based on the RRIF withdrawal tables published in December of 2021, minimum RRIF withdrawals only exceed 8.5% when a retiree turns 85. A hypothetical RRIF holding only HDIF would very likely not have to draw down any of its principal until a retiree turns 85 because the income generated by the ETF could be drawn upon for withdrawals instead.

While tax factors and market-related risks can’t be avoided entirely, equity income ETFs, especially those with high target yields, can help to manage and offset some of the drawbacks that come with RRIF drawdowns.

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