Considerations For When To Convert Your RRSP To A RRIF
Registered accounts like Registered Retirement Savings Plans (RRSPs) can only be used to defer tax for so long. Eventually, an accountholder needs to take withdrawals.
Although there are rules around the latest you can wait to make this decision, there can be cases when early withdrawals make sense. There are also different options to consider for the account that can impact your tax planning and investment strategy.
RRSP Tax Deferral
When you contribute to an RRSP, you can claim a tax deduction on your income tax return. The contribution is effectively deposited pre-tax to the RRSP account as a result. The account grows, largely tax-deferred, until withdrawals are taken.
RRSPs are not completely tax-deferred because there can be withholding tax on certain types of investment income. Notably, withholding tax applies on dividends from non-North American stocks, as well as foreign dividends, including U.S. dividends, earned by a Canadian mutual fund or Exchange-Traded Fund (ETF).
When you take withdrawals from your RRSP, the full amount is taxable as income. The notable exceptions are for the Home Buyer’s Plan (HBP) withdrawals for an eligible first home purchase and Lifelong Learning Plan (LLP) withdrawals for qualifying post-secondary education.
Registered Retirement Income Fund (RRIF) Conversion
Most people convert their RRSP to a Registered Retirement Income Fund (RRIF). Cash and investments can be transferred from an RRSP to a RRIF on a tax-deferred basis.
The latest you can elect to convert your RRSP is December 31 of the year you turn 71, though you can do so earlier. In the year following RRIF conversion, there is a minimum withdrawal required. It is a percentage of your account value on December 31 of the previous year, and the percentage rises with age.
You can elect to base the withdrawal percentage on your spouse’s age. This is most commonly done when your spouse is younger than you to reduce the required minimum withdrawal.
You can convert some or all of your RRSP to a RRIF. You can have multiple RRSP and RRIF accounts.
Other Registered Accounts
Other tax-sheltered retirement accounts like Defined Contribution (DC) pension plans, locked-in RRSPs, and Deferred Profit-Sharing Plans (DPSPs) have similar rules and options as RRSPs.
However, registered accounts from pension plans have maximum annual withdrawals. Some locked-in accounts in some provinces or territories may allow unlocking to withdraw funds or transfer some or all of the account to a regular RRSP under certain circumstances.
Pension Income Splitting
One of the benefits of converting your RRSP to a RRIF is that you may be able to elect to split your withdrawals with your spouse or common-law partner. RRIF withdrawals are considered eligible pension income starting at age 65. Eligible pension income can be split on your tax return.
You and your spouse can jointly elect to have qualifying RRIF withdrawals and other eligible pension income moved between your tax returns. Up to 50% of a spouse’s eligible income can be split.
This can result in lower combined tax payable on the same level of income if a lower-income spouse has income transferred to them.
This is one reason to consider converting your RRSP to a RRIF before age 71.
Pension Income Amount
If you have eligible pension income, up to $2,000 federally and between $1,000 and $2,000 provincially/territorially qualifies for a non-refundable tax credit. This reduces the tax payable on eligible RRIF withdrawals or other eligible pension income.
This can be one reason to convert your RRSP to a RRIF once you are 65, beyond the pension income splitting opportunity.
Annual And Lifetime Tax
Tax deferral is often advantageous, but not always. There may be opportunities to take withdrawals from your RRSP or RRIF and pay a lower rate of tax by conceding some tax today rather than deferring tax as long as possible.
As a simple example, a senior aged 65 or older with $40,000 per year of RRIF withdrawals will pay about $3,000 per year in tax. Those same $40,000 of annual withdrawals over three years may result in about $10,000 of cumulative tax.
By comparison, a single $120,000 withdrawal in the third year—the same total withdrawals over the three-year period—may result in about $29,000 of tax.
The same withdrawals result in very different tax outcomes. The tax deferral could feel good in the first two years, but make someone worse off in the long run. Similar tax-saving opportunities can result from less extreme scenarios.
Annuities
You can use your RRSP to buy an annuity. You do not have to convert your RRSP to a RRIF. You can do this at any time, even after you have already converted your RRSP to a RRIF.
Insurance companies sell annuities. An annuity will pay a monthly payment to the purchaser in exchange for a lump sum of savings today. You hand over some, or all, your retirement account, in exchange for a monthly pension-like payment.
Annuities may have guaranteed periods to protect your beneficiaries if you die an early death. If you live to 110, the beauty of a lifetime annuity is that it keeps on paying. It is also an easy way to generate a retirement income and “buy” a pension for someone who does not have a pension plan.
You can use a portion of your RRSP or RRIF to buy an annuity. It is not an all-or-nothing decision.
Advanced Life Deferred Annuities
Advanced Life Deferred Annuities (ALDAs) were introduced in 2020 in the federal budget. They allow an RRSP or RRIF accountholder to buy an annuity for up to 25% of their account value, to a maximum of $180,000. The funds must be directly transferred from another registered account such as an RRSP, RRIF, DPSP or RPP.
An ALDA can have withdrawals deferred no later than age 85. What this means, practically, is that some of your tax-deferred retirement income can be deferred longer than age 72. This is because an ALDA purchase reduces your minimum withdrawals from your RRIF.
RRSP Withdrawals
You can take withdrawals from your RRSP directly. You do not need to convert it to a RRIF. Other than the aforementioned exceptions for HBP and LLP withdrawals, an RRSP withdrawal is generally taxable.
Locked-in Retirement Account (LIRA) may need to be converted into a Life Income Fund (LIF) or similar eligible account to take withdrawals. If an employee terminates employment before they are eligible to receive a pension, their pension funds can be directly transferred to a LIRA, but the plan still follows the rules of the original pension plan.
There is a withholding tax on RRSP withdrawals that increases with higher withdrawals. Depending on your other sources of income, the tax withheld may not be sufficient to cover the full income tax owing.
Summary
RRSPs are generally converted to RRIFs at some point. You have other options like annuities and ALDAs. There may be reasons to consider early RRSP to RRIF conversion, mostly for tax-saving opportunities.
You should consider your personal circumstances to try to figure out the best option for you from a tax, investment, and estate perspective.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.