This common question usually arises when one spouse has retired while the other is still working. The spouse that has retired has no income, and they see these years as a good opportunity to make RRSP withdrawals before CPP income and RRIF minimums bump them up into a higher tax bracket. Knowing that you can earn up to $11,474 of income without paying Federal tax, it seems like an obvious decision. Take $11,474 out of the RRSP at a 0% tax rate, contribute it to your TFSA, and when you take it back out of the TFSA in the future, you won’t pay any tax. Seemingly the perfect move.
As with many things in personal finance, this is more complicated than it seems. In any year that you have no income, your spouse is able to claim something called the spousal amount on their tax return. It’s kind of like that $11,474 that you can earn tax-free transfers to your spouse if you have no income in a given year. This applies at both a Federal and Provincial level, though the amount is smaller at the provincial level. The result is a Federal tax credit of $1,721, and a provincial tax credit of $429 – that reduces the amount of income tax that your spouse has to pay by $2,150. On top of that, on $11,474 of income, you would still owe $74 of provincial tax.
Let’s say that your RRSP has $11,474 in it and you decide to leave it there, earning 5%. Your spouse has also saved $2,150 in tax, which we can deposit in a TFSA, also earning 5%. Five years later the RRSP is worth $13,497, and the TFSA is worth $2,703. Now it’s time to make an RRSP withdrawal to supplement income. We will say that income is taxed at 30%, and we are below the threshold for OAS claw-back. Withdrawing the full $13,497 results in an after-tax value of $9,763. The total after-tax combined value of the RRSP and TFSA $12,466.
Alternatively, let’s say that you decide to take the $11,474 in your RRSP as income. It is your only income source for the year. We will ignore withholding tax on the RRSP withdrawal. The value of the RRSP drops to $0, and the TFSA is worth $11,474. With the loss of the spousal credit, your spouse now has to pay an additional $2,150 in tax, and you owe $74. We will deduct these amounts from the value of the TFSA, leaving a balance of $9,250. After five years at 5%, this is worth $11,243.
It can be seen from the calculations that we were better off leaving the money in the RRSP. However, this changes if we factor in OAS claw-back. When your income is above a certain threshold, you lose $0.15 of your OAS pension for every dollar that your income exceeds that threshold. The number is $73,756 in 2016, but it is indexed each year, so we do not know what it will be five years from now.
If we run the same two scenarios again with OAS claw-back factored in, assuming that every dollar of RRSP income will trigger OAS claw-back, leaving money in the RRSP becomes less favourable. OAS claw-back will remove an additional $2,092 from the equation, dropping the value of the RRSP and TFSA to $10,374 in the case of leaving the money in the RRSP. The scenario where we moved money from the RRSP to the TFSA is not affected by OAS claw-back because TFSA withdrawals are not taxable income.
If there is no OAS claw-back, we prefer to leave the funds in the RRSP in a no-income year. If OAS claw-back will be a factor, moving money from the RRSP to the TFSA can be a good strategy. This leaves us with two unknowable variables: what will your taxable income be in retirement, and what will the threshold for OAS claw-back be at that time. Making an RRSP withdrawal in a low-income year is not as obviously beneficial as it seems.