“Rules of thumb” are just that – general concepts or strategies that can be useful most of the time. But in every situation, these general rules must be checked against the facts. You never know what you might find when you dig into a specific situation. One of these arose recently to challenge the “rule” that you should always maximize your contributions to a Tax-Free Savings Account. Turns out, this isn’t always the case.
We came across this interesting case at Nelson Financial the other day when preparing some estate projections for a couple of our retired clients, both of whom are approaching their late 70s. They currently live in Manitoba.
The traditional RRIF withdrawal strategy
The question was whether or not it made sense for the husband to take extra income out of his Registered Retirement Income Fund (RRIF) and invest it in his TFSA. His income is more than sufficient, and his goal is to maximize his estate. In many situations this would seem the practical thing to do, because this would probably minimize taxes in the estate down the road. Given their age and stage in life, it is becoming clear that they will not be spending all of their capital. Therefore, as the risks of running out of money disappear and as the risks of inflation seem well under control, our attention begins to shift to the estate plan.
In this situation our clients have a sizeable amount in their RRIFs. We estimated that they could take out an additional $15,000 of RRIF income while remaining in Manitoba’s 34.75% marginal tax rate. These additional withdrawals are not required to meet their monthly expenses.
However, when he passes away, the value of the RRIF would most likely push the tax rate on his RRIF into Manitoba’s top 46.4% tax bracket. So it seemed appropriate that taking money out of his RRIF and investing in the TFSA could save the client up to 11% tax on the amounts withdrawn. That could be approximately $1,700 per year in tax savings based on the $15,000 figure we estimated earlier. If the client were able to make these extra withdrawals for the next 10 years, it could save him roughly $17,000 in tax, not an insignificant figure.
Estate plan conflict
However, an interesting twist came when we reviewed the details of the bequests in the wills. It stated that one third of the estate value was to be donated to a designated registered charity. Assuming that the executor elected to use this donation to offset the realized income from the maturing RRIF values, it offset most, if not all, of the taxes payable by the estate in the final return.
In effect, a provision of the will had defeated the very purpose of the original strategy to minimize taxes by funding the TFSA with extra RRIF withdrawals.
We are reminded that when it comes to estate planning, money is going to go into one of three areas: your children/beneficiaries; the tax department; and/or a charity. By leaving the funds in the RRIF, the charitable donation was larger, the taxes in the estate were lower, and more funds transitioned to the beneficiaries from the remaining estate.
Three key planning points
This scenario underscores three important points when it comes to applying rules of thumb:
1. The importance of getting all of the information regarding your situation when making long-term financial planning decisions.
2. The importance of connecting the dots between different aspects of the overall plan (that is, connecting the dots between the portfolio, the income plan, the tax return, the will, and the ultimate estate plan).
3. The importance of always testing and modelling your assumptions. General rules of thumb are important, but to determine whether these assumptions are correct, it is extremely important to do the math.
Courtesy Fundata Canada Inc. © 2015. Doug Nelson, B.Comm., CFP, CLU, CIM, is President of Winnipeg-based Nelson Financial Consultants. This article is not intended as personalized advice.
