Collapsing an RRSP – Part 2
In part one of this article, we discussed transferring an RRSP to a Registered Retirement Income Fund. This article will review the options for lump-sum payments and the purchase of an annuity.
Lump Sum Payments
Individuals can close their RRSP and withdraw the funds as a lump sum payment. Conventional wisdom suggests this is least favourable option due to the negative tax implications. By including the lump sum payment in income, it may push the individual into a higher tax bracket. There may be an absolute tax savings if individuals bring the RRSP into their income over a period of years so that tax is not paid at the top marginal rate. This may not be as important if individuals are in the highest tax bracket when they retire, but this option will eliminate any tax-free deferral obtained by keeping the funds in a tax-sheltered vehicle.
Although lump-sum withdrawals are not the preferred strategy, it may be a useful tactic in the period between the individual’s retirement and when the RRSP is transferred to an annuity or RRIF. Assume an individual retires at age 58 and does not intend to collapse the RRSP until age 71. In this interim period, the individual may require funds to finance his lifestyle, if the investment income from other sources is less than expected. Monies withdrawn from an RRSP as a lump sum payments are subject to the following rates of withholding tax:
Withdrawal Federal Withholding
less than $5,000 10%
$5,000 to $14,999 20%
$15,000 plus 30%
Purchasing an Annuity
The proceeds of an RRSP can be used to purchase an annuity, normally from an insurance company. The individual will receive a monthly income for the remainder of his or her life. The amount of the monthly annuity will be determined by the following factors:
the amount contained in the RRSP
the interest rate as of the date the annuity is purchased
the age of the individual
insurance company selected
guaranteed payment options
The first two factors are straightforward. The larger the amount of money transferred from the RRSP to purchase an annuity, the greater the monthly payments. The higher the interest rates at the date of purchase, the higher the monthly payments. Under a life annuity, the insurance company will make monthly payments throughout the life of the annuitant. On average, a younger individual will live for more years than an older person, thus will receive annuity payments over a greater period of time. As a result, the younger the individual, the lower the monthly payments that will be received. All insurance companies do not offer identical monthly payments on the purchase of an annuity. Thus, comparison shopping is in the best interests of the purchaser.
The basic concept of an annuity is that an individual receives a fixed stream of payments for the remainder of his or her life. If a sixty-year-old person transfers $100,000 from her RRSP to purchase an annuity and dies three months later, the annuity payments would stop. If she lived to the age of 110, she would receive monthly payments for another fifty years. There are guarantee periods available to offset the risk of an early death, but purchasing these options will reduce the amount of monthly payments received.
Disadvantages of Annuities
In addition to purchasing an annuity during a period of low-interest rates, there are a number of potential disadvantages of annuities as compared to a registered retirement income fund. These include flexibility and inflation protection.
Once an individual starts to receive annuity payments, the stream of payments will continue throughout the individual’s life. It does not provide a source of emergency funds should one encounter an immediate need for cash. An RRIF on the other hand only requires a minimum annual withdrawal, so additional funds can be withdrawn if the individual encounters cash flow issues.
Annuity payments are normally fixed throughout one’s lifetime; therefore, inflation protection becomes an issue. With an RRIF, the minimum withdrawals are increasing on an annual basis, which provides basic inflation protection. Individuals who purchase an annuity may wish to consider adding an inflation protection option which will increase the annuity payments on an annual basis. Selecting this option will lower the initial annuity payments, but the annual increase in payments can offset the impact of inflation.
Types of Annuities and Guarantee Periods
If the annuity option is selected instead of an RRIF, individuals must determine which type of annuity best suits their needs. The purchase of a life annuity will provide individuals with a monthly stream of income until their eventual death. Alternative annuities available to individuals include:
• life annuity
• life annuity, with a joint survivor option
• life annuity with a guarantee period
• joint life annuity with a guarantee period
• term certain age 90
Life Annuity – Life annuities provide a fixed monthly income for the rest of one’s life. However, the individual gives up flexibility by selecting the annuity option but receives a guarantee that the payments will continue until death. This type of annuity does not leave an estate nor provide income to dependents after death.
Life Annuity with a Joint Survivor Option – This is similar to a life annuity, except that payments will continue until the death of both the individual and his/her spouse. The individual will receive a reduced annuity payment for selecting the joint survivor option. The younger the individual and/or the spouse, the lower the monthly annuity payments.
Life Annuity with a Guarantee Period – This is similar to a life annuity, except the annuity payments are guaranteed for a specific period of time such as 15 years. If the individual selects a life annuity with a guarantee period, the monthly payments will be reduced. If the individual dies during the guarantee period, the commuted value of the annuity will pass to the individual’s beneficiaries.
Joint Life Annuity with a Guarantee Period – If this option is selected, the individual will receive a stream of income until the death of the individual and his/her spouse. If both individuals die before the expiry of the guarantee period, the commuted value of the annuity will be transferred to the selected beneficiary of the last spouse to die.
Term Certain Age 90 – This option gives the individual monthly income until age 90. If the individual dies before age 90, the remainder of the annuity will be transferred to a beneficiary. Since most individuals die before age 90, this option will normally leave funds to the estate.
Life Insurance Company and Bankruptcy – What protection is available if the insurance company paying the annuity goes bankrupt? Assuris is a not for profit organization that protects Canadian policyholders if their life insurance company should fail. If an individual is receiving an annuity from a life insurance company which becomes insolvent, the maximum protection for annuities is up to $2,000 per month or 85% of the promised monthly benefit, whichever is higher. If the monthly annuity exceeds $2,000 and since there is an 85% maximum payout, individuals could purchase annuities from more than one insurance company to reduce the risk of lost income. This should ensure that the annuitant would be unaffected in those rare circumstances when a life insurance company goes bankrupt.
Comparing Annuities and RRIFs
Choosing between an RRIF and an annuity is not a mutually exclusive decision. For example, an individual with $200,000 in his RRSP could transfer $100,000 to an RRIF and purchase an annuity for $100,000. Key factors to consider in deciding which retirement option is best suited for your circumstances include:
Guaranteed Payments – An annuity will provide a stream of payments that will be received until death, whereas the amount in an RRIF is impacted by the rate of return on investments and any lump sum withdrawals that are taken.
Change in Circumstances – Once an annuity is purchased; the investor is locked in. However, funds in an RRIF can later be converted to an annuity.
Inflation Protection – Unless inflation protection is obtained at the time the annuity is purchased, the payments are fixed for life. The withdrawal formula for an RRIF results in increased payments over time, but there is no correlation to the rate of inflation. However, the withdrawals could be structured to provide a source of inflation protection.
Flexibility – Annuity payments are locked in for life, whereas the RRIF guidelines only provide minimum annual withdrawals. As a result, individuals have access to additional funds when they are required.
Age Issues – A RRIF must be purchased by December 31 of the year the individual turns 71, but they can be purchased earlier if so desired. There are no age restrictions on the purchase of an annuity.
Tax Sheltering – Annuity payments are taxable in the year received, whereas investment income retained with the RRIF is not taxable.
Conclusion – Individuals must decide whether a registered retirement income fund or an annuity is more appropriate in their circumstances. An annuity provides a guaranteed source of income for a pre-determined period. As a result, individuals are less vulnerable to marketplace volatility, as compared to registered retirement income funds. Since payments are constant each month, there is normally no inflation protection with annuity purchases. The RRIF alternative provides more flexibility, greater control over the assets and an increased ability to direct funds to beneficiaries. The life annuity may provide the highest level of monthly income of the various annuity options, but individuals will achieve the greatest benefit from annuities if they outlive their estimated date of death contained in the life expectancy tables used by insurance companies.
