Retirement and withdrawals commutated value in the form of a lump sum, it provides flexibility and control over pension funds. However, it can also lead to significant tax liabilities if not handled carefully. Fortunately, there are ways to do this commute to retirement without charging high taxes. In this article, we’ll discuss strategies that can help you minimize taxes while commuting to retirement and ensure you keep as much of your retirement savings as possible.
What does it mean to commute to retirement?
Down commute to retirement means converting future pension payments into a lump sum amount, the so-called commutated value. This allows you to take control of your retirement savings by transferring them to a tax-sheltered account, e.g blocked retirement account (LIRA) or registered retirement savings plan (RRSP) or investing them in other financial products.
Trade-in value is the present value of all future payments you will receive from your retirement plan. These calculations take into account factors such as your age, life expectancy and current interest rates. When you reach retirement, you get a lump sum, which gives you more control over how you use the money, but it also comes with potential tax consequences.
Tax consequences of commuting to retirement
When you’re reaching retirement, one of the biggest challenges is dealing with the tax consequences. The Canada Revenue Agency (CRA) has strict height rules commutated value can be transferred to registered accounts in a tax-protected form. The portion exceeding this limit will be taxed as regular income, which may result in high tax.
Maximum transfer value
The CRA sets a limit on the amount of work credit that can be transferred to tax-sheltered accounts such as an RRSP or LIRA. This limit is called the so-called maximum transfer value. A portion of your converted value up to the maximum transfer value can be transferred tax-free, but any amount above this limit will be paid to you in cash and taxed as income in the year you receive it.
For example, if the converted value is $500,000, a maximum transfer value is $350,000, the remaining $150,000 should be treated as a taxable lump sum. Depending on your tax bracket, this could move you into the highest tax bracket and result in a significant tax bill.
How to minimize taxes while commuting to retirement
Fortunately, there are several strategies you can use to minimize the taxes you’ll pay while commuting to retirement. With careful planning and using the right tools, you can reduce your tax impact and keep more of your hard-earned retirement savings.
1. Use the RRSP Common Room
One of the most effective ways to reduce taxes while cruising into retirement is to use up any unused funds RRSP Contribution Room you can have. By contributing the taxable portion of the converted value to your RRSP, you can offset taxes that would otherwise be due on that amount.
For example, if you have $50,000 in unused RRSP contribution room and your commute value exceeds the amount maximum transfer value o $50,000 you can contribute an additional $50,000 to your RRSP. This will allow you to defer tax on this amount, effectively reducing your tax liability for the year.
Be sure to check the latest Notice of Assessment (NOA) available on the website Canada Revenue Agency or with your financial advisor to confirm how much RRSP contribution room you have available before reaching retirement.
Some employers allow you to put any surplus directly into your RRSP. This is the easiest way. Other employers refuse, so once you receive the lump sum, you’ll have to put the money into your RRSP. Then top up with other available cash OR a line of credit.
Why not borrow to contribute to your RRSP? Your loan cost may be 1/2% per month for several months. Your tax savings could be 30% or more. Top up your RRSP when your annual income is at its highest.
2. Trip schedule
Here’s the scenario. Let’s assume Rob retires in September. Its converted value is settled in December. Therefore his cash surplus subject to taxation, falls in the same tax year, i.e. the calendar year, as his income. Therefore, his gross annual income is extremely high.
Bill is retiring in October. He receives his final pension declaration in November, BUT he has 60 days to respond. Bill submits the signed documents on January 1. Bill gets his cash surplus in February. Therefore, this income does NOT put Bill in a high tax bracket. Voila.
3. Share your income with your spouse
If you are over 65, you may qualify for distribution of retirement incomewhich allows up to 50% of your qualifying retirement income to be allocated to your spouse or civil partner. This can reduce the family’s overall tax burden if your spouse is in a lower tax bracket.
Retirement income sharing applies to certain types of retirement income, including: annuities to be paid purchased with pension funds. If you reach retirement and transfer funds to an annuity, you may be able to share the annuity income with your spouse, reducing the amount of taxable income on your behalf.
This strategy can help you keep more of your retirement income and potentially avoid being pushed into a higher tax bracket.
4. Consider phasing into retirement
Another way to reduce the tax impact of commuting into retirement is to consider a phased approach to withdrawing retirement savings. Instead of accepting the entire converted amount at once, you can transfer the funds to account a lifetime income fund (LIF), registered pension fund (RRIF) or other registered account and withdraw money gradually over time.
By spreading out your withdrawals, you can keep your taxable income lower each year, avoiding a big tax hit in one year. This approach also allows you to continue growing your investments tax-deferred within your registered account, giving you more time to build your retirement savings.
5. Buy a copycat annuity
AND imitative rent is an annuity designed to mimic the payments you would receive from yours defined benefit pension plan. When you reach retirement, you can use the converted amount to purchase an annuity from an insurance company that provides the same or similar guaranteed monthly income. We support this process for you. You don’t pay. We are paid by the insurer.
One of the advantages of purchasing an annuity with your commutated value is that you can spread the payments over your lifetime, reducing your immediate tax burden. Annuity payments are typically treated as regular income and taxed as such, but because the payments are spread out, the total tax impact is lower than if the entire converted value was taken as a lump sum.
And most often there is a surplus of cash. An insurance company, say Manulife, Sun or Desjardins, does not need the entire converted value to offer you a follower pension. You get the difference in your pocket.
Additionally, annuities are eligible distribution of retirement incomewhich can further reduce your tax liability if you are married or have a common-law partner.
5. Plan your taxes in advance
One of the most important steps you can take to avoid high taxes during your retirement commute is to plan ahead. Working with a financial advisor or tax professional can help you develop a retirement-commuting strategy that minimizes taxes and maximizes retirement savings.
Consider factors like yours RRSP Contribution Roomavailability distribution of retirement incomeand your expected tax bracket in retirement. By planning ahead, you can ensure that you get to retirement in the most tax-efficient way possible.
When should you consider commuting for retirement?
Commuting into retirement is a big decision, and it’s not the right choice for everyone. However, there are certain situations where commuting into retirement may make sense:
You want to have more control over your retirement savings
If you’re confident in your ability to manage your own retirement savings, commuting into retirement can give you more control over how you invest and withdraw your money. This may be particularly attractive if you have experience managing investments or want the flexibility to access larger sums of money in retirement.
You have a shorter life expectancy
If you expect a shorter life expectancy due to health problems, commuting until retirement may make sense. Taking commutated value allows you to use the money for other purposes, such as medical expenses, or pass it on to your heirs, rather than relying on a monthly pension that you may not fully benefit from.
You want to leave a legacy
If leaving an inheritance to your loved ones is important to you, commuting into retirement gives you more control over what happens to your remaining funds after your death. WITH defined benefit pension planpayments usually stop when you and your spouse die, unless there are special survivor benefits. Taking commutated valueyou can pass the remaining funds to your heirs.
You want flexibility
If you need flexibility in your retirement planning – whether it’s big expenses, travel or business ventures – retirement commuting gives you the freedom to use your money as you see fit. This flexibility can be attractive to retirees who want to take a more active role in managing their finances.
When is it better to leave your pension in place?
Although commuting into a pension provides flexibility and control, there are times when it is better to leave the pension in place and receive monthly payments:
- You want a guaranteed income: If you prefer the certainty of knowing, you will get a constant, guaranteed one monthly income for life, leaving your pension in place is the safest option.
- You don’t want investment risk: Managing commutated value means taking on the risk associated with making the investment. If you’re not comfortable with that risk or don’t want to manage your own investments, staying in a pension may be a better choice.
- You expect a long life: If you have a long life expectancy, a guaranteed income from retirement can give you peace of mind knowing you won’t outlive your retirement savings.
Final thoughts on commuting to retirement without high taxes
Commuting into retirement offers flexibility and the potential for higher returns, but it also comes with tax challenges that need to be managed carefully. Using strategies such as maximization RRSP Contribution Roomusing distribution of retirement incomeand gradually withdrawing funds, you can minimize your tax burden and keep more of your retirement savings.
Before deciding whether to commute into retirement, it’s important to consider your personal financial situation, health and retirement goals. Working with a financial advisor can help you create a tax-efficient retirement plan and ensure you get the most out of your retirement savings.
