When looking at investments opportunities, the number 1 rule is to always think after tax. Investment incomes are taxed just like employment income but some investments are taxed differently and at different rates. Take two different investments; one pays 10% and the other pays 12%. On the surface, the 12% looks better. However, if the 10% was dividends from companies and the 12% was interest from bonds then the picture completely changes. Divides are taxed at a much lower rate than interest. This is why when you’re deciding what to invest in, you must look at the tax impact.
The impact taxes have on an investment is huge. The best way to show this difference is by comparing a tax sheltered investment vs. an unsheltered investment. Let’s assume you have $10,000 to invest for your retirement. If you were to put this $10,000 inside your RRSP (401K or IRA in the US), any income the investment makes is completely tax-free until you take it out. If you were to leave the funds inside for 30 years and average 10% return, you would have $174,494.02 at the end of 30 years to help fund your retirement.
If you were to invest this $10,000 outside of a RRSP, the income it makes will be subject to tax at your marginal rate. If you’re at the 40% tax bracket, it would mean $400 in taxes in the first year ($10,000 at 10% return = $1,000 @ 40% tax = $400 in taxes). That leaves only $600 to put back into investments, where as the RRSP will allow you to put the full $1000 back. The impact over 30 years is huge. Instead of having over $174K for retirement, you’ll have just $57,434.91.
Even if you were to withdraw the entire $174K and pay the maximum 48.6% withholding tax, you’ll still come out ahead of the game because you shelter the income for the past 30 years. However, there are ways to get the money out with little or no tax impact.
The first way is to transfer the money into a Registered Retirement Income Fund (RRIF) and have it pay you the yearly tax free amount. In Canada you’re allow to make $8,000 a year tax-free (the amount increases every year). If you set up the RRIF to give you $8,000 per year (adjusted to the yearly increases), you can effectively take the money out over time without paying any taxes â€“ assuming you can live on $8,000 a year, which is not very likely. However, if you have funds from other sources, like a reverse mortgage or money borrowed against a life insurance policy (these are not subject to tax) then this retirement trick can work.
The other way to minimize the tax is be retire outside Canada. Unlike the US, Canada taxes its citizens based on residency. If you leave or retire outside of Canada, you are no longer subjected to Canadian tax, even though you’re still a Canadian citizen. If you wait until you become a non-resident (six month plus a day outside of Canada), you can withdraw all the funds inside your RRSP by paying a 25% withholding tax. This a lot better than paying 48.6%.
Another way to minimize the tax on the money taken from your RRSP is to take a series of smaller payments instead of collapsing it all at once. As long as you withdraw no more than $5,000 at a time, the withholding tax is only 10%. Therefore, it is possible for a non-resident to exhaust their RRSP over time at a cost of only 10%. This wouldn’t work as well if you stayed in Canada because the amount you withdraw will be added to your total income at tax time and Revenue Canada will then get their share. However, a non-resident no longer has to fill or pay Canadian income tax.