A retiree whose retirement savings are primarily in a registered savings plan, such as a life income fund or registered retirement income fund, already faces a number of risks and challenges during their retirement years.
But a significant financial market correction highlights one of these challenges — how much income should be withdrawn from the individual’s savings during the period shortly after the market correction and what are the consequences?
In order to illustrate this challenge, consider the example of Nancy who is a retiree and was age 75 at the beginning of 2020 with a locked-in registered account (i.e., a LIF) of $400,000. In March 2020, the COVID-19 pandemic caused a major financial market correction, with a significant drop in equity values and extreme volatility in both the equity and fixed income markets. In early April 2020, Nancy is considering how much income to withdraw from her LIF in 2020, which is now valued at $350,000 compared to $400,000 at the beginning of the year.
Minimum and maximum withdrawals
The amount of income that a retiree withdraws each year from their registered savings plan is affected by minimums required by the Income Tax Act. Also, if the savings were accumulated in a registered pension plan and are therefore locked in, they’re likely to also be affected by withdrawal maximums imposed by pension legislation:
- Beginning in the calendar year after the year an individual turns age 71, the Income Tax Act requires a minimum annual withdrawal from a registered savings vehicle. The minimum annual withdrawal amount is determined as the account balance at the beginning of the year multiplied by a percentage, with the percentage based on the individual’s age. For example, the percentage is 5.82 per cent for a 75 year-old and Nancy would normally have to withdraw a minimum of $23,280 (5.82 per cent of $400,000) from her LIF in 2020. However, due to the financial market correction that occurred in early 2020, a special amendment was made to the Income Tax Act to reduce minimum 2020 withdrawals by 25 per cent. Therefore, Nancy must withdraw a minimum of $17,460 (75 per cent of $23,280) from her LIF in 2020.
- In addition, pension legislation often limits the annual amount that can be withdrawn from a locked-in savings account, with the method for determining the limit depending on the province in which the individual was employed. For example, since Nancy was employed in Ontario prior to retirement, her annual limit is determined by taking her account balance at the beginning of the year and multiplying it by a percentage, with the percentage based on her age. Since this percentage is 9.71 per cent in calendar year 2020 for a 75-year-old, Nancy can withdraw no more than $38,840 (9.71 per cent of $400,000) from the account during 2020. Ontario pension legislation also permits an annual withdrawal up to the amount of the investment return earned by the individual’s account in the previous year.
Minimize the withdrawal?
When a retiree withdraws income from their savings account shortly after a market correction, chances are they’re selling their assets at a low or depressed value. This reduces the amount of savings that will benefit from future investment returns, including any future bounce back that may occur in the financial markets. Also, the amount the retiree withdraws from a registered account such as a LIF or a RRIF was earning investment returns on a tax-deferred basis, but withdrawals are taxed as income in the year of withdrawal. Even if the retiree is able to replenish some or all of the withdrawn savings in the future, this can’t be done on a tax-deferred basis unless the retiree is less than age 71 at the time and has sufficient unused registered retirement savings plan contribution room.
Preferring to withdraw as little savings as possible shortly after a market correction, Nancy determines she can get by if she withdraws only $10,000 from her LIF in 2020. However, the Income Tax Act will require her to withdraw at least $17,460. While this is better than the usual minimum withdrawal of $23,280 for a 75-year-old, $17,460 is still more than she would like to withdraw.
A retiree who withdraws more than is needed from a LIF or RRIF can consider contributing the extra money to a tax-free savings account. Although the contributions aren’t tax deductible, the investment earnings in the TFSA aren’t taxed and neither are the withdrawals. The TFSA contribution limit is $6,000 for 2020, but a retiree may be able to contribute more if they have unused TFSA contribution room from previous years.
Increase the withdrawal?
Although Nancy plans to withdraw the minimum required amount from her LIF in 2020, she also realizes there’s a chance she’ll need to withdraw significantly more. Nancy relies on rental income from a property she owns and, due to the recent economic downturn, there’s a risk the occupants won’t be able to afford to continue paying their rent.
If Nancy’s rental income ceases, she may want to withdraw up to $45,000 from her LIF in 2020 in order to meet her retirement expenses. However, as discussed above, there are significant disadvantages to making withdrawals, especially large withdrawals, shortly after a market correction. Also, pension legislation will only permit her to withdraw up to $38,840 from her LIF in 2020, leaving her $6,160 short of her desired income.
In most jurisdictions, pension legislation allows an individual to unlock an additional amount from a locked-in arrangement in certain cases of financial hardship, which could include income falling below a specific threshold or requiring monies to pay rent or mortgage payments.
The withdrawal dilemma
As seen from Nancy’s situation, determining how much retirement savings to withdraw shortly after a market correction can be challenging. On one hand, it’s preferable to withdraw as little savings as possible. On the other hand, the economic circumstances associated with the market correction may create the need to withdraw more income than usual (i.e., at the worst possible time). Layered onto these challenges is the fact that, for savings in registered vehicles, the retiree’s flexibility may be limited by minimum required and maximum permissible withdrawals imposed by tax rules and pension legislation.
This dilemma is a reminder of the importance of educating Canadians about the financial risks and challenges they may face during their retirement years. It also raises the question of whether some of the restrictions on withdrawals imposed by the Income Tax Act and pension legislation should be relaxed during times of extreme financial market volatility, so that retirees have additional flexibility to manage their financial affairs.