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How to Avoid the Dreaded Old-Age Clawback
05/31/2011 10:28 am EST
After striving to save for retirement, people can be resentful when their required withdrawals from retirement plans will result in the elimination of Old Age Security benefits, writes Rob Carrick, reporter and columnist for The Globe and Mail.
Not much gets retirees riled up like the clawback of Old Age Security benefits.
Financial planner Daryl Diamond recalls hearing from one woman who had retirement savings in the low seven-figure range, and was distraught over having to pay back her OAS.
"It was absolutely crushing her," he recalls. "It was going to ruin her retirement that she was going to have to give up all of the OAS payment."
Diamond is an expert in retirement income planning, and he has a solution for retirees with substantial savings who are upset about having to repay their OAS benefits. By carefully managing withdrawals from registered retirement savings plans and registered retirement income funds, it's possible for them to keep their taxable income low enough to retain the full OAS amount.
Let's get something straight up front, though. The OAS clawback does not actually have a huge negative impact on your income in retirement.
"On a net, after-tax basis, it's nominal," said Diamond, who runs Diamond Retirement Planning in Winnipeg and is the author of Your Retirement Income Blueprint: A Six-Step Plan to Design and Build a Secure Retirement.
"But it's just absolutely sand in people's gears. They say, wait a minute, I scrimped and saved and put all this money away and because I did a really good job, I'm being penalized?"
OAS is a federal social program designed to provide a very modest pension to low- to middle-income retirees. The maximum monthly benefit right now is $526.85, or $6,322.20 a year. The clawback of OAS benefits starts with a net income of $67,668, and it completely eliminates OAS with income of $109,764.
Diamond's clawback-avoidance strategy contradicts the conventional thinking that money should be left in a tax-sheltered retirement plan as long as possible. His view is that you can end up with too much money in your registered retirement plan.
You may, for example, have enough in your RRSP that your assets will keep growing even as you start making withdrawals. When you turn 71 and convert your RRSP into a RRIF, you may find that meeting the required annual minimum withdrawal puts you into OAS clawback territory.
Diamond's solution is to take more than you need out of your RRSP in your early retirement years, pay the tax on it and then park it in tax-efficient investments. By shrinking your RRSP, you put yourself in a position to draw less from your RRIF and thereby keep your total income low enough to keep all OAS benefits.
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A first step is to figure out what your net income in retirement will be. Maximum CPP and OAS benefits would give you $17,842.20 right now if you retire at 65. Add any company pension to which you're entitled, and then estimate how much you'll be removing from your registered retirement plan each year. With RRIFs, there's a mandatory minimum annual withdrawal amount.
Your total income is reduced by any tax deductions you have, but they'll be typically be minimal. Seniors generally qualify for tax credits (they reduce tax owed) rather than tax deductions (they reduce taxable income).
Diamond said that if your net income is within the first federal tax bracket—that's income of up to $41,544 for 2011—there's no need to worry about avoiding the OAS clawback.
On the surface, higher net incomes may not be a concern if they're still below the $67,668 threshold where OAS clawbacks begin. But Diamond likes to consider what would happen to a retiree's taxable income if his or her spouse were to die. In that case, assets in the registered retirement plan of the deceased spouse would be transferred to the survivor, potentially bumping up his or her income into OAS clawback range.
If it looks like your taxable income in retirement will be close to the OAS clawback threshold, or if you'd reach this point when your spouse dies, then one approach would be to simply withdraw extra amounts from your RRSP for a few years or more. Another option is what Diamond calls his "Topping Up The Tax Bracket" strategy.
Let's say you projected an income in the $67,668 range once your RRIF is up and running in the future. What you'd do is top up your withdrawals from your RRSP to an extent that your total taxable income (including all sources) is just below the $83,088 limit for the second federal tax bracket.
Essentially, you're taking out more than you need to shrink your RRSP, and limit the risk that your RRIF withdrawals will put you in OAS clawback range later on.
"All we're trying to do is keep the RRSP's value in check," Diamond explains.
Note: You may face a modest amount of OAS clawback in the near term by topping up your tax bracket. But later on, when you're into your RRIF years, ideally you would not be in clawback range any more.
Withdrawing more money than you need is not the same as spending more than you need. In fact, your excess withdrawal amounts should go directly into a tax-free savings account, subject to you having contribution room.
TFSAs have only been around since 2009—with the annual contribution limit at $5,000, the maximum contribution room would be $15,000.
Take the rest of your excess RRSP withdrawals and invest them in corporate-class mutual funds, advises Diamond. Corporate-class funds are a special type of mutual fund that has three big tax benefits for people making non-registered investments:
- You can take money out of one fund and move it into another without the transaction being viewed as a sale for tax purposes.
- These funds are run in a way that produces few, if any, taxable distributions.
- Investment gains, whether from stocks or bonds, are almost exclusively treated as capital gains (only 50% of the gain is taxable).
Diamond stresses that corporate-class funds aren't a perfect tax shelter. However, they are a highly tax-efficient way to invest outside a registered plan.
One investment you'll want to be careful with when parking excess withdrawals from a registered plan is dividend-paying stocks. In calculating the favorable tax rate on dividends, you must "gross up" the amount of dividends you received in a way that increases your taxable income.
Here's an example from Diamond: You receive $10,000 of dividends from a blue-chip Canadian stock, which requires you to gross up that amount by $4,100. Thus $14,100 would be added to your total income for the year, potentially cutting into your OAS benefits.
Avoiding an OAS clawback will take some doing, but Diamond's view is that many people will find the effort worthwhile.
"Every time somebody ends up losing some of that OAS benefit, it's like the worst thing in the world."