The clawback of old-age security pensions has raised a lot of concern recently. Many Canadians have been left wondering whether they should limit the size of their RRSPs in order to avoid the clawback. Advisors are divided on the subject.

While some advisors suggest clients should accumulate as much as possible in their RRSPs, others promote the advantages of saving in non-registered vehicles to avoid being saddled in retirement with a huge RRIF that requires regular withdrawals of taxable income.

In reality, most concerns about the OAS clawback are unwarranted, as only a small number of people are affected.

“The OAS clawback is not an issue for the vast majority of Canadians,” says Malcolm Hamilton, pension consultant with Toronto-based Mercer Human Resources Consulting Ltd. “Most Canadians over 65 do not have sufficiently high incomes for the clawback to kick in. For those with high incomes, the clawback is an annoyance and is unfair.”

Philip Kung, president of Markham, Ont.-based RGI Financial Inc. , maintains people with sufficiently high incomes do not even think about the clawback. “It does not deter them from building wealth for their retirement — whether it’s inside an RRSP or outside — as it is relatively insignificant,” he says.

The OAS pension is a taxable benefit that is indexed quarterly to changes in the consumer price index. The maximum benefit, currently $479.83 a month, is payable to individuals who are 65 years old and older who have lived in Canada for 40 years or more after turning 18. A partial benefit is paid to individuals who have lived in Canada for at least 10 years after age 18. Residence in a country with which Canada has a social security arrangement may count as Canadian residence for the purpose of determining the OAS entitlement.

As of October, OAS clawbacks became effective for individuals who have net income of more than $60,806. For every dollar above this threshold, the OAS pension is reduced by 15¢, and it becomes zero at a net income of $98,850. According to Ottawa-based Social Development Canada, about 5% of seniors now receive reduced OAS pensions due to the clawback, while only 2% lose the entire amount.

David Karas, president of Money Concepts Barrie in Barrie, Ont., sees changes to the structure of the OAS in the future and, consequently, does not believe it should be a consideration in retirement planning. He argues that an aging population will put increasing pressure on the public retirement system, forcing changes to the OAS rules.
“There’s no confidence in what benefits you’ll get,” he adds.

Avoidance tactics

Although many advisors say the clawback should not be an issue, strategies have been developed to avoid it. The thinking behind these strategies is that because an RRSP is converted into a RRIF, the client with all of his or her holdings inside a tax-deferred program has no control over the withdrawal schedule nor, hence, the level of income. If retirement funds are held outside a plan, however, investors have the opportunity to control the level of income, the type of income (such as dividends, which are taxed at a lower level than interest income) and the timing of realized capital gains.

Although Kung does not recommend it, he says an advisor could estimate retirement
income from an RRSP by making certain assumptions in order to determine whether an individual would be affected by the OAS clawback. But, he cautions, there are many uncontrollable variables, such as future investment growth and inflation rates, to take into consideration, making the projection complex.

“It is not the prudent thing to do, and is unnecessary for most people,” he says.

Lou D’Aversa, director of business development at Stratos Wealth Management in Toronto, advises: “If an investor is close to retiring and has a borderline situation, then perhaps some tax planning and/or tax-timing strategies can be beneficial if the investor can avoid the clawback. However, you have to weigh the benefits with the costs for each individual, as every situation is different.”

The choice of accumulating as many funds as possible in RRSPs vs in non-registered vehicles is based on personal circumstances. For instance, most low-income individuals do not even have sufficient money to maximize their RRSP contributions.

John Williamson, federal director of the Canadian Taxpayers Federation in Ottawa, says moderate-income individuals should not put money in RRSPs, in order to avoid the clawback. “Canada has the highest tax rate on people who are in retirement,” he says

@page_break@Williamson echoes the findings of the April 2003 CD Howe Institute study New Poverty Traps: Means-testing and modest-income seniors, written by Richard Shillington. It says that for many lower-income Canadians, RRSPs are “a terrible thing.” Shillington found that even a $100,000 RRSP may not put low-income retirees ahead of those who save nothing and live off the guaranteed income supplement (GIS) and other government programs. The GIS is a monthly benefit paid to Canadians who receive the OAS pension but have little or no other income. Shillington’s argument is based on the fact that each dollar of retirement income from a RRIF reduces GIS benefits by 50¢. Since GIS recipients pay taxes, their effective marginal tax rate is higher for the additional income.

“Little or no informed financial advice specific for lower-income Canadians exists,” Shillington argues, “so they tend to accept the same advice widely publicized for the general population: that RRSPs are the most effective vehicle for saving for retirement.” He advocates a tax-prepaid savings plan as a savings vehicle for low-income Canadians.
TPSP contributions would not benefit from an up-front tax deduction, but investors would be able to make tax-free withdrawals and, therefore, not trigger the clawback of government benefits.

But regardless of income levels, says Steve Salter, president of Vancouver-based Fimetrics Systems Ltd. : “RRSPs should be the first choice to save for retirement.” He argues that the clawbacks are taking place “way out in time” and that the “time value of money has to be taken into consideration.” Salter, who developed RRIFmetic financial planning software, claims that RRSPs are a good choice because taxes are usually lower in retirement (plus Canadians benefit from the age credit, the $1,000 pension tax credit and the disappearance of employment insurance and CPP withholdings); tax brackets are indexed; and the time value of money is positive — that is, the amount of taxes paid in, say, 2030 has to be looked at in present-value terms.

Salter uses the following example to demonstrate his claim: “Taxes on $50,000 are currently $11,200 — and it would have remained at $11,200 each and every year, if indexation to inflation was not introduced. Now, if inflation runs at 2%, taxes on $50,000 in 10 year’s time will be $9,700; and in 20 years, $8,500; $7,900 in 30 years; and $7,000 in 40 years. At 3% inflation, taxes after 60 years will be just $1,000. The case for saving outside the RRSP is hard, if not impossible to make.”

D’Aversa agrees: “By choosing to invest outside the RRSP, you are using after-tax dollars, so you immediately have less money to start with. In addition, the growth is being continuously taxed at your marginal rate, which further stunts your investment value over the long term. So you’re giving up a great deal of benefit today for a future benefit that may not be material.

“RRSPs remain the single best way for most Canadians to fund their retirement while gaining an immediate tax deferral and by sheltering future gains,” he contends, “allowing the positive effects of tax-free compounding and growth to work its magic.”

Karas believes that once an individual has accumulated a certain amount in an RRSP, the person should consider non-registered investments that also offer tax benefits — for example, structured products such as flow-through securities, partnerships, trusts/ corporations and leveraged loans. “People should structure their capital to alter taxation,”he says, to concentrate on creating tax-effective cash flow “instead of income
that is fully taxed.”

In as much as Karas believes investing in an RRSP is important, he says the ongoing focus on RRSPs is a “mindless, repetitive strategy” that doesn’t make sense. “People tend to treat RRSPs as a sacred cow. But they should simply be slush funds that constitute a
basic pension plan that is available when required,” he says.

Hamilton sums it all up: “When it gets to the point that you have used up all your RRSP room, you should invest in equity-type investments outside your RRSP and keep income-type investments in your RRSP” because of the more favourable tax treatment of capital gains.
At the end of the day, Canadians ultimately aim to save as much as possible for retirement inside or outside of their RRSPs. After all, contributions to an RRSP are restricted to annual limits. Ultimately, the OAS clawback affects only a small number of Canadians and should not be an important consideration for financial advisors. IE