You must act by Dec. 31!
If you turned 71 this year, and you still have an RRSP, you have until Dec. 31 this year to convert it into another type of tax-sheltered plan. If you don’t, the Canada Revenue Agency can take away up to half of whatever is in your RRSP. Here’s what you absolutely need to know about RRSP maturity options.
If you miss the Dec. 31 deadline for converting your RRSP into one of the available maturity options, the Canada Revenue Agency will deem that you have deregistered (collapsed) your RRSP. What this means is that for income tax purposes, the entire amount of your RRSP will be considered to be part of your income for this year.
If your RRSP is sizable, taking it all into income could push you into a much higher tax bracket. You’ll then pay tax on the entire RRSP amount at that higher rate, and that could be over 50%. In addition, the higher income could reduce or make you ineligible for various income-tested government benefits and tax credits. Old Age Security payments, for example, are clawed back in part or entirely above a certain income threshold. In addition, once you collapse your RRSP and bring the proceeds into regular income, you will no longer have the advantages of tax deferral that you enjoyed in your RRSP.
If you turned age 71 at any time this year, it’s therefore essential that you choose an RRSP maturity option before Dec. 31. Here are your choices:
- Registered Retirement Income Fund
When you convert part or all of your RRSP into a Registered Retirement Income Fund (RRIF), investments in the RRIF continue to grow sheltered from tax as long as they are in the plan. Note that investments eligible for RRIFs are the same as those for RRSPs. With a RRIF, however, you must begin withdrawing a minimum amount from the plan every year starting the year after the plan is set up. Withdrawals from a RRIF are considered income for tax purposes, and are therefore taxable at your top marginal rate in the year of withdrawal. The annual minimum withdrawal is calculated by multiplying the market value of your RRSP account on December 31 of the previous year by a percentage pre-set by the government. Note also that while you must withdraw a minimum, there is no annual maximum withdrawal amount.
Minimum RRIF withdrawal amounts are calculated by RRIF withdrawal factors set on a sliding scale by the Canada Revenue Agency. The withdrawal factors increase as you age. For plans RRIFs established before 2015, you must withdraw 7.38% of the value of the RRIF if you are 71, increasing to 8.99% by age 81 and 20% by age 94. For RRIFs established in 2015 and subsequent years (including 2016), the minimum withdrawal factor at age 71 has been reduced to 5.28%, climbing to 7.08% at age 81, and 18.79% at age 94.
- The annuity option
Another RRSP maturity option, although one that has been less popular in recent years, is the purchase of an annuity contract. Very simply, an annuity provides a guaranteed income stream for life. When you purchase an annuity, you essentially buy a contract under which the issuing company (usually an insurance company) invests the lump sum you provide and guarantees a regular payout over the life of the annuity contract.
There are several types of annuities. For example, a “Term Certain Annuity” guarantees a monthly income for as long as you want, up to age 90. If you die before all payments are received, the balance will go to your estate. Another option is a “Life Annuity,” which guarantees a monthly income for as long as you live. However, payments stop when you die, and no money will go to your estate.
Because annuities are ultra-conservative products, they are typically tied to the level of prevailing interest rates. And those rates have been ultra-low since 2008. Annuity rates have thus been also been correspondingly low, making annuities a less desirable RRSP maturity option than RRIFs for the past few years. However, this may be changing as rates rise.
Annuities are complex products, and it is important that you understand how interest rates and other factors affect how much income you will receive. It may not be advisable to convert all of your RRSP into an annuity – this will depend on your investment objectives and risk tolerance. I recommend seeking the advice of your financial planner and/or a licensed insurance agent to discuss annuity options and how they might best fit into your overall retirement plan.
- The hybrid option
Many people who must choose an RRSP maturity option opt for some combination of an active RRIF portfolio and an annuity to continue providing growth, inflation protection, and a guaranteed income stream. Another option may be to invest a portion of your portfolio in an insurance product that offers a guaranteed income withdrawal feature.
This type of product is similar to an annuity in that it guarantees a specific regular monthly, quarterly, or annual payment until you pass away. But unlike an annuity, you can cash in the policy and take the “cash surrender value” if your situation changes dramatically and you need the cash. (But I do not recommend taking the cash out of this type of policy except as a last resort.)
Cover minimum income first
When considering retirement income options, especially when converting an RRSP, always make sure you have the minimum income you need to live on. Annuities or an insurance product with guaranteed income withdrawal are two options, but these can be complicated, so I’d recommend talking to a qualified insurance specialist first. Then diversify the balance of your holdings into a RRIF portfolio that will continue to generate some capital appreciation and growth along with an income stream (e.g., from dividends).
© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.