Canada’s retirement income system is often referred to as a three-part system. Individuals earning income from employment or self-employment can contribute to a registered retirement savings plan (RRSP) and withdraw funds from that plan in retirement. A much smaller (and shrinking) group of Canadians will receive income in retirement from an employer-sponsored pension plan. Finally, there are two government sponsored retirement income programs. Under the first, Canadian retirees who participated in the paid work force during their adult life will have contributed to the Canada Pension Plan (CPP) and will be able to receive CPP retirement benefits as early as age 60.
The second federal government retirement income program – the Old Age Security (OAS) program – is different from all other retirement income programs in that it does not require an individual to make contributions to the program during his or her working life in order to receive benefits in retirement. Rather, entitlement to OAS is based on the number of years of Canadian residence, and individuals who are resident in Canada for 40 years after the age of 18 can receive full OAS benefits. As of the fourth quarter of 2022, those full OAS benefits are equal to $685.50 per month.
The OAS program is distinct from other sources of retirement income in another, less welcome way, in that it is the only retirement income source for which the federal government can require repayment by the recipient. That repayment requirement comes about through the OAS “Recovery Tax”, which is universally known as the OAS “clawback”.
While the rules governing the administration of the clawback can be confusing, the concept is a (relatively) simple one. Anyone who receives OAS benefits during the year and has income for that year of more than (for 2022) $81,761 must repay a portion of the OAS benefits received. That repayment, or clawback, is administered by reducing the amount of OAS benefits which the individual receives during the next benefit year.
Since the OAS clawback affects only individuals who have an annual income for 2022 of at least $81,761, it’s arguable that at such income levels, the clawback requirement does not impose any real financial hardship. Nonetheless, the OAS clawback is a perpetual irritant to those affected, perhaps because of the sense that they are being penalized for being disciplined savers, or good managers of their finances during their working years, in order to ensure a financially comfortable retirement.
While any sense of grievance can’t alter the reality of the OAS clawback, there are strategies which can be put in place to either minimize or, in some cases, entirely eliminate one’s exposure to that clawback. Some of those planning considerations are better addressed earlier in life, prior to retirement, However, it’s not too late, once one is already receiving OAS, to make arrangements to avoid or minimize the clawback.
In all cases, no matter what strategy is employed, the goal is to “smooth” one’s income from year to year, so that net income for each year comes in under the OAS clawback threshold and, not incidentally, minimizes exposure to the higher federal and provincial income tax rates which apply once taxable income exceeds around $100,000.
The starting point, for taxpayers who are approaching retirement, is to determine how much income will be received from all sources during retirement, based on CPP and OAS entitlement, any savings accrued through an RRSP, and any amounts which may be received from an employer-sponsored pension plan. Anyone who has an RRSP must, by the end of the year in which they turn 71, convert that plan into a registered retirement income fund (RRIF) or purchase an annuity. Under either scenario, the taxpayer will begin receiving income from the RRIF or the annuity in the following year. However, it’s possible to begin receiving income from an RRSP or an RRIF at any time. Similarly, an individual who is eligible for CPP retirement benefits can begin receiving those benefits anytime between age 60 and age 70, with the amount of monthly benefit receivable increasing with each month receipt is deferred. The same calculation applies to OAS benefits, which can be received as early as age 65 or deferred up until age 70.
Once the amount of annual income is determined, strategies to smooth out that income can be put in place. One of those strategies is to withdraw income from an RRSP or an RRIF prior to age 71, so as to reduce the total amount within the RRSP or RRIF and so thereby reduce the likelihood of having a large “bump” in income when required withdrawals kick in at that time.
Taxpayers are sometimes understandably reluctant to take steps which they view as depleting their retirement savings, but receiving income from an RRSP or an RRIF doesn’t have to mean spending that income. While tax has to be paid on any withdrawals (no matter what the taxpayer’s age), the after-tax amounts can be contributed to the taxpayer’s tax-free savings account (TFSA), where they can earn investment income free of tax. And, when the taxpayer has need of those funds, in retirement, they can be withdrawn free of tax and won’t count as income for purposes of the OAS clawback or any other tax credits or benefits.
Taxpayers who are married can also “even out” their income by using pension income splitting, so that neither of them has sufficient income to be affected by the clawback. Using pension income splitting, the spouse who has income which exceeds the OAS clawback threshold re-allocates the “excess” income to his or her spouse on the annual return, and that income is then considered to be income of the recipient spouse, for purposes of both income tax and the OAS clawback. To be eligible for pension income splitting, the income to be reallocated must be private pension income, which is generally income from an RRSP, RRIF, or annuity, or from an employer-sponsored pension plan.
There are two reasons why pension income splitting is a particularly attractive strategy for avoiding or minimizing the OAS clawback. First, there is no need to actually change the source or amount of income received by each spouse, as the reallocation of income is “notional”, existing only on the return for the year. Second, no decision has to be made on pension income splitting until it’s time to file the return for the previous year, meaning that spouses can easily calculate exactly how much income has to be reallocated in order to avoid the clawback, and to reduce tax liability generally. More information on the kinds of income eligible for pension income splitting, and the mechanics of the process, can be found on the CRA website at https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/pension-income-splitting.html.
The information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Please contact our office for more information on this subject and how it pertains to your specific tax or financial situation.
