Three ways to use your funds – and how they work
Gen-Xers, Gen-Yers, and Millennials should all have RRSPs. Sadly, most do not. The smart ones do, and are taking advantage of the powerful long-term compounding and tax-sheltering benefits of this wonderful retirement plan. Because one day you will retire. Just ask the Baby-Boomers, who are retiring in droves right now. The smart ones of that generation opened up RRSPs early, and many of those with 30 or 35 years of contributions are sitting on RRSP nest-eggs worth a million bucks or more. The big question for them is what to do with that pot of gold now.
The RRSP rules are very clear. By the end of the year in which you turn 71, you will need to collapse your RRSP. And you have three choices for what to do with the funds. You can take the entire amount into income (not very tax-effective if the RRSP is one of those big million-dollar ones), purchase an annuity, or convert your RRSP into a Registered Retirement Income Fund (RRIF). Or, you can arrange for some combination of these choices.
Three maturity options
1. The RRIF alternative
A RRIF is much like an RRSP in that investments in the plan continue to grow sheltered from tax. The twist is that you must withdraw a minimum amount from the RRIF every year. That income then becomes 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.
The RRIF rules state that in the year after you open your RRIF, you must withdraw 7.38% of the value of the RRIF. This increases over time so that by age 81, the minimum annual withdrawal is 8.99% of assets. By age 91, the minimum annual withdrawal becomes 14.73%, climbing to 20% by age 94.
2. The annuity option
Another common RRSP maturity option is the purchase of an annuity contract to provide a guaranteed income stream. An annuity is an insurance-based income product. Putting it very simply, 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 set 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 set monthly income for as long as you live. However, payments stop when you die, and no money will go to your estate.
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 invest all of your investments 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.
3. “Pensioning” retirement income
I am a firm believer in “pensioning” your retirement income. To do this, you can 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.)
Ensure minimum income
My advice is always to make sure your retirement “nut” is covered first. Ensure you have the minimum income you need to live on. An insurance product with a guaranteed income withdrawal is one option, 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 portfolio that will generate some capital appreciation and growth into the future.
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.