In the last months, many of you have requested an article about my future withdrawal strategy.
Actually, I had already broached the subject in my article called Living Off Passive Income. However, there are so few resources on withdrawal strategies for (very) early retirement that I thought it would be useful to elaborate a bit more on the subject. In addition, our friend FIRE Habits recently wrote about his own withdrawal strategy (French). I thought it would be interesting to elaborate on my own strategy. This way, you’ll have access to two different strategies for two completely different situations.
As he puts it so well in his article (free translation), “There are as many withdrawal strategies as there are tax specialists.”
Of course, this following strategy may very well change along the way. You never know what life will bring, after all. Based on my projections as of today, I will outline my strategy as a single woman without children.
I am not a financial advisor, tax specialist or retirement planning specialist. Nor am I accredited by law to make financial recommendations. This article will not provide any financial advice. I will only attempt to explain how I plan to live off passive income, to the best of my knowledge. The goal is to provide an example of a strategy and perhaps get some of you to think about building your own.
The Different Sources of Income
First of all, the most confusing part of living off our passive income is the many possible sources of income upon retirement. These different sources of income vary as much from a tax point of view as from a temporal point of view.
Here are the sources of income I’ll have access to, as well as their important aspects to consider.
Withdrawals from an RRSP will be taxed at the same rate as income. It offers flexibility by having no maximum withdrawal limit. However, once a withdrawal is made from an RRSP, the contribution space is not recoverable. It disappears forever.
In addition, regardless of the amount withdrawn, your financial institution must withhold income tax at source. If you ended up paying too much, the amount will be returned to you the following year after doing your tax return. We certainly don’t like to make a 0% interest loan to the government, but that’s the way our wonderful tax system works.
An RRSP can also be transferred to a Registered Retirement Income Fund (RRIF).
At the latest, an RRSP must be transferred to a RIFF at age 71 and a minimum annual withdrawal is then established based on age. For example, the minimum withdrawal rate at age 71 is 5.28% and increases as you get older. This rate is therefore higher than the 4% rule. Compared to an RRSP, you cannot add funds to a RRIF.
My research did not identify any advantage to transferring an RRSP to a RRIF in the context of early retirement. Do not hesitate to correct me if I’m wrong on this one!
Those who have been reading this blog for some time already know that I currently contribute to a defined benefit pension plan (DBPP) through my employer. Once I resign, I plan to take the commuted value. Part of that amount will go to a Locked-In Retirement Account (LIRA). I have already been down that road in the past. Therefore, I’ll have a considerable amount of money in my LIRA.
What are the specifications of this account? It’s actually quite similar to an RRSP. The LIRA contains money that has never been taxed. This means it will be taxable as income at the time of withdrawal.
However, the only way to withdraw income from it is to transfer the money first into a Life Income Fund (LIF).
In Quebec, we are quite lucky. In fact, there is no minimum age required to transfer one’s LIRA into a LIF. However, I understand that it is not as simple for other provinces or for LIRAs under federal jurisdiction. Thus, my strategy only applies to Quebec laws. It may not apply to your specific situation.
Once the LIF is set up, you can withdraw one of two types of income from it.
The main thing to remember about Life Income is that there is a maximum to how much can be withdrawn each year. The maximum is calculated based on age, the LIF balance, and the reference rate set each year for LIFs (6% in 2021). The idea behind this is that it must last for the rest of your life.
Thus, this type of income has many more limitations than RRSPs.
Temporary income, on the other hand, offers more flexibility. In fact, it allows withdrawals of up to 40% of the value of the MPE, or $24,640 in 2021. A specific request must be made each year to your financial institution to benefit from it.
To qualify, Retraite Québec specifies that the following two conditions must be met:
- You must have only one LIF;
- The gross amount of other income for the 12 months following the application for temporary income must not exceed 40% of the MPE for the year of the application.
Also, like an RRSP, the LIRA must be transferred into a LIF no later than age 71 and is subject to a minimum annual withdrawal based on age.
For my specific situation, I should be eligible for Temporary Income as my total gross income should not exceed 40% of the MPE. I will therefore have more flexibility than if I only had access to the Life Income.
Retraite Québec also offers a calculator to help you get an idea of how much and what kind of income you can get from your LIF.
What else can we say about the TFSA other than it is a gift from heaven?
After contributing amounts that have already been taxed, withdrawals and investment income are not subject to taxation.
That means there’s no downside to letting your TFSA grow as long as possible. The TFSA will provide non-taxable income. Let me rephrase that:
The longer you let the TFSA grow, the more non-taxable income you’ll have.
In addition, unlike an RRSP, any withdrawal from the TFSA will free up contribution room for the following year. In other words, if you withdraw $10,000 from your TFSA one year, you can put that $10,000 back the following year.
In addition, there is also the new annual limit. In 2021, that was $6,000 in additional TFSA contributions. Of course, this may change in the future, if the government finally realizes how much tof a weapon of mass tax destruction the TFSA is. 😉
Non-Registered (or Taxable) Account
Non-registered accounts have no minimum or maximum withdrawal amount. They allow you to receive different investment income, which is subject to different tax rules. As a matter of fact, our friend Felipe described them perfectly in a recent video. Basically, here’s what you need to keep in mind.
Dividends have preferential tax treatment thanks to tax credits. Dividends from Canadian shares are taxed even less. The tax credits are in fact so generous that, in the absence of other income, a single person can receive up to almost $50,000 in dividends without paying a single dollar of tax. It’s also important to remember that dividends are subject to tax from the moment they are deposited, even if you plan to reinvest them.
Some ETFs are designed to pay no dividends. These types of ETFs simplify this tax aspect.
The capital gain, or profit realized on the sale of an asset, is taxed more favourably. In fact, the income inclusion rate is only 50%. At least for now.
For example, a stock bought at $100 and then sold at $120 represents a realized capital gain of $20. However, only 50% of this gain, or $10, will be subject to taxation.
The major advantage of this type of income is that it has to be declared only when the gain is realized, i.e., when the asset has been sold. That means you can defer a capital gain for as long as needed.
Interest income is the least tax-efficient type of investment income. This is because interest income is taxed at the same rate as regular income.
Keep in mind that bonds generate interest income. Because this type of income is taxed much less favourably, it is best to keep your bonds in a registered account, unless you hold a bond ETF that does not pay out any distributions.
Public Pension Plans
Now, the different sources of income to which I’l be entitled at the traditional retirement age should not be overlooked either. Of course, I’m referring to public pension plans such as Quebec Pension Plan (QPP), or CPP for the rest of Canada, and Old Age Security (OAS).
The QPP pension is based on the income on which one has contributed. Thus, it is difficult to estimate one’s pension will look like in several years or even decades. Fortunately, QPP gives access to an individual’s participation statement on its website. In section 3, there’s the current monthly amount. This amount represents a retirement pension estimate, if no other income is added to those already registered until then.
The most important thing to remember is that QPP is taxable and can be received as early as age 60. From ages 60 to 70, the pension varies greatly. Exactly the same applies to CPP.
OAS and GIS
Unlike QPP, OAS is based on the number of years someone lived in Canada after the age of 18.
In 2021 dollars, the maximum monthly OAS pension is $615.37 taxable (or $7,384.44 per year). It can be received as early as age 65, but it can be deferred until age 70. The longer it is deferred, the higher the pension will be each month.
If someone’s net income exceeds $79,845 (including OAS benefits), a portion of the OAS must be repaid. No pension is paid when the net income exceeds $129,075. Fortunately, this should not apply to me. 🙂
On top of this, there is the Guaranteed Income Supplement (GIS). Unlike OAS, GIS is non-taxable. In 2021 dollars, any single person with less than $18,648 in taxable annual income (including OAS) can receive up to $919.12 more per month (or $11,029.44 per year) as GIS.
CRA states that there is no benefit to defer the pension when eligible to GIS.
Asset Allocation and Asset Location
You might remember I previously discussed this in my article about how to invest your savings. However the subject is still as relevant, if not more so, when it comes time to make a withdraw from your nest egg.
In addition to choosing a stock/bond ratio we’re comfortable with, it is important to put the right things in the right places. There are two simple and good reasons: return and tax optimization.
So, let’s take a look at the relevant aspects of stocks and bonds.
Of course, stocks are relevant everywhere. Stocks will get us good long-term return and will ensure the sustainability of our portfolio. Regardless of the stock/bond ratio chosen, there is a high probability of having some stocks in every account. However, in my opinion, the TFSA remains the account to be prioritized. It’s where you want maximum returns.
Historically, there is a difference in returns between global and Canadian stocks. Therefore, it would be appropriate to concentrate the better-performing portion (global stocks) in the TFSA and the less performing portion in the RRSP/LIRA (canadian stocks).
Remember that bonds offer more short-term stability, but they necessarily slow down return. On top of that, they produce interest income that is heavily taxed. Considering this, the logical choice is to keep bonds in a RRSP/LIRA. Unless you hold a swap-based bond ETF, there is no benefit to having bonds in a non-registered account.
The last place to hold bonds is a TFSA. The last thing we want is to slow down its return and amputate our future tax-free income.
My Future Portfolio
Considering all of the above, here’s what my portfolio could look like when time comes to withdraw. As I explained in a previous article, I will have kept enough RRSP room to absorb my DB pension commuted value excess. So, once the commuted value is factored in, my portfolio should look like this :
|Non-registered||$40,000||9%||HGRO||50% on capital gains
While still in the accumulation phase, I currently hold 100% stocks ETFs (ZGQ and XEQT). However, once I get closer to having to live off my nest egg, I plan to make the transition to something around 90% in stocks and 10% in bonds. Yes, I have a very high-risk tolerance. 🙂
Since RRSPs and LIRAs act in a fairly similar fashion, that means about 61% of my portfolio is subject to being taxed just like income. I intend to hold my 10% in bonds (ZAG) there, given the less than advantageous tax treatment of interest income. Also, since bonds will slow down my return, I prefer holding it in my RRSP/LIRA. I’ll also focus my home country bias there (XEQT).
About 30% of my portfolio will be concentrated in my TFSA, and will provide non-taxable income. In it, I will hold 100% global stocks (ZGQ) to allow it to grow as much as possible. Remember that there is no disadvantage to having a very large TFSA. 🙂
As for the non-registered account, it will be a meager 9% of my portfolio. By holding only a 100% stocks ETF with no taxable distribution (HGRO), only capital gain will be taxable. The tax treatment will therefore be much more advantageous than my RRSP/LIRA.
My Withdrawal Strategy
Keep in mind that the Canadian tax system is a progressive system, which means that low income is taxed at a lower rate than a high income. The more taxable income you earn, the more tax you pay.
Knowing this, we need to be careful not to receive too much taxable income all at the same time. Keep in mind that QPP and OAS will be taxable at a later date. At the same time, let’s not forget that the RRSP/LIRA will have to be mandatorily transferred to a RRIF/LIF at age 71 and will be subject to a predetermined minimum withdrawal (certainly higher than 4%).
Thus, I see my withdrawal strategy in two stages.
Before Age 65
Remember that the RRSP/LIRA is taxed more heavily, the non-registered account is taxed more advantageously and the TFSA is not taxed at all.
Considering this, I will prioritize making withdrawal from my two most heavily taxed accounts, i.e., my RRSP and my LIRA. Since I am aiming for a frugal retirement, my withdrawals should be close to the basic personal amount. Anything above could come from the non-registered. Thus, I would pay very little tax, even when making withdrawals from my most heavily taxed account.
I could also slowly transfer money from my non-registered account to my TFSA. That is, if we keep having new contribution room each year. I somehow doubt that, but let’s keep on dreaming.
That way, I’ll delay withdrawing from my TFSA as long as possible. In the meantime, it will continue to grow. When the time comes to withdraw from it, i.e., once the RRSP/LIRA and non-reg are fully depleted, my TFSA will provide 100% tax-free income. This will come at a good time, since taxable income from QPP and OSA will inevitably come into play.
After Age 65
It is quite difficult to estimate my future QPP pension, as I intend to stop contributing to it, or at least contribute very little, long before I am entitled to it. As for what age I’ll start receiving QPP and OAS, I am far from having made up my mind. Regardless of the age and amount, we need to remember it’ll still be taxable income.
So, if I’ve already completely depleted my RRSP/LIRA and my non-registered account, I’ll only have one other source of income left at that time. That is, of course, my TFSA, and the income will be entirely non-taxable.
Thus, in the absence of other taxable income, QPP and OAS pension will be taxed much more favourably (if at all). In addition, I will most likely have access to the GIS. Those public pension plans additional income should then allow me to slightly reduce my TFSA withdrawals to less than 4% per year. This should further ensure the sustainability of my portfolio.
The Opposite Strategy
For many, withdrawing from an RRSP at age 35 is sacrilege. Yet, it’s really the most optimal way to withdraw from your portfolio, now that the TFSA is part of the game.
Imagine the opposite strategy.
I’d start withdrawing from my TFSA from the get-go. I’d enjoy a tax-free retirement income for maybe 10-15 years and then it’d completely depleted.
Once that’s done, all I’d have left would be taxable income. While I was depleting my TFSA, my RRSP/LIRA and my non-registered account would have grown. I’d probably start withdrawing from those at around age 45-50.
At 60-65 years of age, QPP and OAS would kick in. At age 71, my RRSP/LIRA would need to be transferred to a RRIF/LIF and would be subject to a minimum withdrawal of 5.28% and more per year. If all those different sources of income put together end up being too high, I would not be eligible for the GIS and I would be taxed at a higher tax bracket.
Isn’t it better to spread taxable income over the entire retirement period?
Withdrawing During an Apocalypse
Of course, there are also some strategies in case of a disaster. Whether it’s problems in your personal life or a stock market crash, you need to know how to adapt your withdrawal strategy.
Personally, I don’t believe in keeping the equivalent of several years’ worth of cash on hand. Currently, in my accumulation phase, I don’t even have an emergency fund. In this respect, this article is very relevant to me. Once I retire, I will possibly keep 3-6 months of cash expenses, at most, but certainly not the equivalent of several years. This small emergency fund could be useful in the event of a correction to avoid selling at a loss.
In the event of a bear market while I need to withdraw, I’d choose to sell bonds rather than stocks at a loss. Considering that I should have 10% of my portfolio in bonds, this represents about 2 and a half years of annual expenses.
I also don’t rule out the possibility of further reducing my expenses, or simply working, albeit temporarily. There is no shame in that.
Dividends could also be used as income instead of being reinvested. It would not require to sell anything at a loss, since that money would already be sitting in cash.
So, that was a brief overview, which I’ve even touched on before, but which may require an article of its own at some point in the future. 🙂
So that was my strategy with the data I have as of today. I am very well aware that 1,001 things can change until then. However, to achieve a goal in life, you have to plan ahead. A goal without a plan is a dream. You plan with what you know, and adjust as you go along.
If you fail to plan, you are planning to fail.
– Benjamin Franklin
I am not a professional and there are certainly things I forgot or neglected to take into account. Feel free to let me know what I might have forgotten. However, I believe that considering the lack of resources on the subject, it is relevant to start the conversation and exchange on the subject.
Have you thought about your own withdrawal strategy? 🙂