"The trick is to stop thinking of it as 'your' money - I.R.S. Auditor
Rate of Return vs. Tax Implications in Retirement
The above quote sure seems to hit home doesn't it? People know the effect of taxes on paychecks today – it’s pretty clear just by looking at a paystub. Something that is much more misunderstood is the effect of taxes on our retirement. This notion that we don’t need to concern ourselves with that because our tax bracket will be lower in retirement is complete rubbish. Why on earth would it be lower in retirement? Aren’t you planning on maintaining your lifestyle in retirement? Maybe the mortgage (maybe!) and kids are no longer around, but you’ll have more time on your hands and have always talked about wanting to travel more and perhaps take up a new hobby or two (which also cost money). So your required and desired income shouldn’t really change much. The reality should be that you plan on being in the exact same tax bracket, especially considering that the cost of living always goes up and you’re going to need more money to buy the same things.
Also, is there a chance that the government will raise taxes again in our lifetime? I know, stupid question. Maybe they will, maybe they won’t. But don’t hold your breath that taxes will ever be lowered. Best case, they stay the same.
So one might start to make the assumption that the government once again has us over a barrel and that we need to just accept our fate and pay our fair share of taxes.
As I have mentioned before, people are often so worried about rate of return. Don’t get me wrong, it is important. But once you have access to a really good money manager, your results aren’t going to vary that much from one to the next. Manager “A” beats Manager “B” this year by 1%. Then next year Manager “B” beats Manager “A” by the same 1%. So don’t blow your brains out by constantly jumping around from one manager to the next. Find a good one and stick with them.
My argument today is that you CAN change your tax bracket downwards while maintaining your same lifestyle. If most of your investments are in the registered environment (RRSPs, RRIFs, LIRAs, etc), you are going to be in the same tax bracket as you are today because drawing from these areas is taxed just like your regular employment income.
Consider diversifying by tax strategy and environment. If you start investing dollars in the open or non-registered area and start getting growth from capital gains, you will automatically cut your tax bill in half in retirement as a worst-case scenario because you only pay tax on 50% of the growth, not the original contribution. You may not get a tax refund for the contribution but the reality is that those refunds are not usually substantial and in my experience, maybe 1% of clients re-invest their refunds rather than blow that money.
Also consider the TFSA where you will be able to access your investments completely tax-free. That’s 0% tax!!!! This also doable in some cash value insurance policies if set up properly. And that’s a strategy that can kill 2 or 3 birds with 1 stone.
Below is an example of the impact of increasing your rate of return by 1% per year on average versus taking advantage of different tax environments. It shows various outcomes of investing $500 per month for the next 25 years. Pay particular attention to the yearly AFTER TAX incomes generated in each scenario.
So the point is – do both. Get a good rate of return by accessing great money managers. Find one and stick with them. At the same time, plan strategically to minimize your tax bill in retirement. And the earlier you start this planning, the better your results will be. These two items together can generate you the retirement lifestyle you want.