Taxes in Retirement

My parents are both retired now. Early retirement for them was 65 and 61. Very surprising, considering the financial mistakes my father made in the last 15 years. It was very fortunate for both of them that my mom didn't make those same mistakes. Also, as a nurse for most of her adult life, she built up her RRSPs and earned a decent pension.

No idea what world my father is living in, though. Over the weekend, he was complaining about them owing the Government over $5,000 in taxes despite being retired.

Frankly, I'm not surprised at the $5,000 in taxes owed. In large part to his past financial indiscretions, my father wiped out his RRSPs to partially pay down a huge debt. Yikes! From my understanding*, the only money he's "earning" is the money from Old Age Security (OAS) and from the Canada Pension Plan (CPP). Let's assume that's $16,000 a year and he's being appropriately taxed for this small amount (Approximately, $500 in taxes).

In order for my parents to be receiving a tax bill of $5,000, I'm going to assume the following:

  1. My mom's income last year was around $55,000
  2. Trying to avoid withholding taxes, they withdrew from her RRSP in increments of $5,000 (or less).
  3. She's earning her pension as a nurse and is only getting taxed at 10%.
  4. She's earning CPP and is also being taxed at 10%. 
As my mom is 61 years old, she only has 10 years or so before she needs to convert her RRSPs to RRIFs. At that time, she'll be forced to take out money from the RRIF on a predetermined schedule. The more money in the RRIF, the more money she'll be forced to take out. That means she'll be in a higher income bracket.

To avoid the taxes associated with the forced withdrawals of the RRIF, she has started to withdraw from her RRSPs.

We all know RRSPs. You put money into them and the Government gives you a tax refund! Awesome! Additionally, money grows inside an RRSP without being taxed! The only thing people forget, is that the Government isn't that generous. RRSPs are only tax deferred. The Government is patiently waiting for their share.

When you withdraw from an RRSP early, the financial institution holding the RRSP will deduct a withholding tax. Depending on the amount you withdraw, the financial institution will withdraw a specific rate as follows:

  • Less than $5,000 = 10%
  • $5,000 to $15,000 = 20%
  • Greater than $15,000 = 30%

So obviously, you'd take money out in increments of $5,000 right? That way you avoid paying 30% tax! Right?


Sadly, the Government has a way of getting this money.

Any amounts taken out of your RRSP is considered as income the year you withdraw the money. If you withdraw $5,000 from your account 8 times, your income from RRSPs is $40,000.

So why do they consider it income?

Well, when you put the money into an RRSP, you're deferring your income to be taxed later. You are receiving the tax refund because you are effectively lowering the amount you earned the previous year. Since the Government taxed you on the amount you didn't earn, they give you money back in the form of a tax refund. It's not free money!

So how did my parents get a tax bill of $5,000?

This is my best guess:

  • In total, my mom earned $55,000 from her RRSP and pensions.
  • They took money out in increments of $5,000 or less and got taxed at a rate of 10%.
  • The total tax they paid thus far was $5,500.
  • According to some nifty tax calculators online, earning $55,000 (in Ontario) means a tax bill of $10,683.
  • Since they already paid $5,500, that leaves $5,183 owing to the Government.

This seems plausible to me.

So how could they have avoiding this tax bill?

For one, my father's financial mistakes forced my parents to work longer than they wanted to. Without this mistake, both my parents could have retired earlier giving them more time to withdraw from their RRSPs before the age of 72.

That means they wouldn't need to take as much money from their RRSPs each year. However, let's just assume they need the $71,000 of income per year.

Assuming they retired much earlier and earned incomes of $35,500 each ($71,000 combined), that gives them a total tax bill of $10,000 (approximately, $5,000 each).

The total amount of taxes they owe for last year's income is $11,000. That's about $1,000 in savings.

Since they don't need $71,000 a year, they would withdraw less from their RRSPs and that would lower the amount of tax owing. For example, $60,000 split equally would result in a total tax bill of $8,000 and $50,000 split equally would result in a total tax bill of $6,000.

Either way, the Government is going to get its share. However, with sound financial planning, you can keep more of that money in your pockets.

*My parents don't share much of the details with me. I have to guess in an attempt to figure these things out on my own.


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