4 ways to cut taxes in retirement

You can’t avoid income taxes during your working life and when you retire, you want to set things up to ensure you pay as little as possible.

There are four common ways to do that. They involve how you use your RRSP withdrawals, maximizing your Tax Free Savings Account, using the Canadian dividend tax credit and taking advantage of pension income splitting.

RRSP withdrawals

If you keep your combined income and RRSP withdrawals below or equal to the federal basic personal deduction of $10,527 per person (for 2011) you pay no federal tax. For most of us, this isn’t very helpful, but if you are a retired couple spending a modest $40,000 per year, you can pay no tax on just over the first 50 per cent of your annual income. If nothing else this is a good start.

Tax Free Savings Accounts

Withdrawals from a TFSA are tax free. In the long run that’s a good thing because we’re getting $5,000 a year in contribution room. A decade from now, if a couple both contributed the maximum $5,000 a year, every year they would have contributed $100,000. Then assuming a modest 3 per cent return per year return that would give them an extra $16,000 in their TFSA’s. They could safely withdrawal about $3,500 per year on a sustainable basis with no extra contributions. Combine this with the first method and that brings up your total tax free income up to $24,500 or 61 per cent of that modest $40,000 per year in spending.

Dividend tax credit

If you buy shares in a Canadian company you get a tax break on the dividends if you hold them in a taxable account. For example, if you own 1,000 shares of BMO, worth about $60,000, you would have received $2,800 in dividends in 2010. If your retirement income was under $37,700 each, you would get a tax credit of about $2,900. So it is entirely possible to use a portfolio of dividend paying stocks to supplement your retirement income at a very low tax rate.

The great thing about these first three methods is they can apply to anyone regardless of their age, so even early retirees can utilize them to keep their tax bill low.

Pension income splitting

The last method to keep your taxes to a minimum in retirement is reserved for those who are over 65. When you hit 65 a few tax rules take effect. The two most important ones are the age amount tax credit and pension splitting. The age amount tax credit is $6,537 per person federally and $4,445 per person in Ontario over and above your basic personal deduction that we have already discussed. While these tax credits don’t have a specific purpose other reducing taxes for seniors, they are useful to offset new taxable income you are receiving from CPP and OAS after you turn 65 (but you have to apply for both programs so don’t forget after blowing out your candles to file your paperwork).

Pension splitting is potentially a great way to even out taxable income for a couple. Here is how it works. First you need to have ‘pensionable income’ which could from a several different sources such as converting some RRSPs to RRIF, buying an annuity with an RRSP or a life annuity payment from a pension plan. Then if you qualify for the pension income tax credit, which is worth $2,000 per person per year federally and $1,259 per person per year in Ontario you can spilt ‘pensionable income’ between you and your spouse. For example, if your spouse collects $20,000 in pension income and the pushes her into a higher income tax bracket you can split that amount into $10,000 each to reduce your tax owning and to also claim the pension income tax credit for both your spouse and yourself.

While all of these methods are useful to reduce minimize your tax bill in retirement the only real way to find if it will work for your situation is to play around with a tax calculator like this one found on taxtips.ca. It’s an excellent way to test run several scenarios on how to reduce your taxes in retirement. After all less taxes means you don’t have to save as much to retire. Now who knew tax time could actually mean some good news for a change of pace.

Tim Stobbs blogs at Canadian Dream: Free at 45.