Tax optimization is an important aspect of retirement planning. Beyond saving, investing, and accumulating wealth, examine how you can reduce the amount of tax you pay when retired.
This article doesn’t go deep into tax issues because each situation is different, with different applicable rules and tax rates. However, there are situations we all have in common upon retirement. After your retirement strategy is outlined, i.e., your global asset allocation, risk tolerance, types of investments, etc., you’re in a good position for some tax tweaking. Don’t do it the other way around.
Why do I believe one should perform tax optimization only after you have set your investing strategy? Because while it’s good to trim your tax burden, you should not do it at the expense of the bigger picture. In other words, I don’t think it’s all that bad to pay withholding taxes on dividends received if it enables you to have a more diversified and better performing portfolio.
See also Create your own Paycheck in Retirement
However, when it’s time to retire, the order and timing of withdrawals can greatly affect your budget. You can’t control your portfolio performance, but you can control a part of the taxes you’ll pay, or save, at retirement. Therefore, crunching numbers with a tax expert is likely to make a big difference in your lifestyle.
Canadians, learn about government retirement benefits. Download our CPP and OAS guide.
My take on tax optimization
I’m not a tax expert, but after doing hundreds of financial plans for my clients as a financial planner back in my banking days, here are my conclusions.
First, know that there are no magic tricks for optimizing taxes. Any strategies viewed as “too aggressive” by regulators will be rejected and you’ll get a slap on the wrist
The best tax advice I can give you is quite simple: spend a few thousand dollars with a fee-based financial planner and an accountant. They’ll do the hard work and offer you a customized plan to optimize your taxes. Make your appointment, develop a plan, and avoid potentially costly mistakes.
To know more ahead of consulting an expert, or if you want to skip consulting and do it yourself, learn about the simple 3 Ds of tax optimization: Deduct – Defer – Divide.
Deduct: maximize deductions, reduce your taxable income
Anything you can use to reduce your taxable income automatically lowers your taxes, especially if you live in a country with increasing marginal tax rates like Canada. Examples of deductions you can use to reduce your income at any age include contributions to your retirement plans, interest paid on loans used to procure non-registered investments, and healthcare expenses.
Defer: postpone paying taxes as long as you can
Here’s a tip for my Canadian readers (I’m pretty sure it applies to Americans too, but you should verify this first). It sounds counter-intuitive, but in most cases, deferring the moment when you withdraw money from your tax-sheltered account (such as your RRSP account) is worth it. Here’s why.
The longer you wait to withdraw money from a tax-sheltered account or to trigger capital gains, the longer your money is growing tax-free. At retirement, it’s usually preferable to let your tax-sheltered account grow while withdrawing money from regular investment accounts, if possible. Remember that all investment income coming from a taxable account, whether it is withdrawn or reinvested, is income in your tax declaration.
Some retirees are tempted to withdraw money from tax-sheltered accounts earlier to pay less tax, as they assume their marginal tax rate to be lower at 60 years of age than at 85, when they anticipate they’ll have to withdraw more money. However, when you withdraw money, you pay the taxes immediately. The money paid to the government can’t compound going forward. Withdrawing at a younger age means you miss out on years of growth on tax paid.
For example, if you need $7,000, you could sell shares in a taxable account and pay a small amount in capital gains. Perhaps you’ll have to sell for $7,500 to receive $7,000 net of taxes. You could also sell for $10,000 in your RRSP to receive $7,000 after taxes. That extra $2,500 paid in taxes won’t compound tax free inside your RRSP for the next 20 years. At a 7% investment return, each $2,500 turns into $9,674 in 20 years from now. That’s almost 4 times the original amount!
Divide: divide your income with a spouse
You can split assets or income sources with your spouse to keep each of your incomes in a lower marginal tax rate brackets. You’ll pay a lot less in tax if you split $100K of income 50-50 than keeping it solely under your name.
Tax optimization take away
Unfortunately, there are no secret ways to make taxes disappear, other than those usually referred to as fraud or evasion. If you’re Canadian and dislike the OAS claw back, look at it this way: being asked to payback some of the OAS benefits you received is a good problem to have; it means you likely have plenty of money to enjoy your retirement.
Canadians, learn about government retirement benefits. Download our CPP and OAS guide.
An accountant can do a great job at drawing up a plan to optimize your taxes; the best way to approach tax optimization is to run multiple scenarios and see the impact of each choice. Don’t forget to always focus on your investment strategy first. Saving money in taxes is great, but making higher total returns is even better! Adding risk or reducing total return for the sake of taxes isn’t a good idea.
