The dirtiest problem in all of finance
Nobel prize winner Bill Sharpe referred to the art of strategically funding your retirement years as the dirtiest problem in all of finance. That is because when it comes to retirement there are more uncertainties than there are certainties. This is not an easy environment from which to make critical decisions of how much money should be drawn from your retirement nest egg and which accounts this money should come. One of the most obvious signs of the difficulty of these decisions can be measured by the frequency with which retirees inadvertently box themselves into one of the many retirement tax traps.
Ideally, your retirement nest-egg is composed of three different account types: Registered Retirement Income Fund (RRIF or LIF), Tax Free Savings Account (TFSA) and non-registered (OPEN) account. When funds are withdrawn, each of these account types have different tax implications. The first is fully taxable, the second is non-taxable the third is partially taxable. Therefore, where you choose to source your funds and how much you choose to withdraw from each of these accounts to meet your annual cash flow needs can have a significant impact on how much income tax you pay. Choose poorly and anticipate getting caught in a retirement tax trap.
In typical fashion the financial services industry has built algorithms that allow you to set the order with which you choose to fully liquidate the funds in each of your account types in succession to fund a recurring annual spending number.
Unfortunately, this simplistic approach to creating a draw down recipe does little more than prove that your draw down choices can have a significant impact on how much of your retirement nest egg is yours to spend and how much ends up in the governments’ coffers. However, as opposed to this simplistic, set it and forget it strategy, you would be far better off to customize your draw-down recipe; drawing differing amounts from each account to strategically exploit tax opportunities that reveal themselves on a year-by-year basis. In other words, you would like a year-by-year recipe that prescribes how much money should be drawn from each account type.
Incrementally the goal of this draw-down recipe should not be to minimize taxes on a year-by-year basis, but to instead, seek to minimize the amount of income tax you pay over the balance of your life. This latter strategy is likely to save you significantly more in taxes; however, it requires the strategic understanding that sometimes it is better to pay a little more income tax earlier on in your retirement as opposed to paying a lot more later in life.
There are some who compare the strategic skills of determining the optimal recipe for sourcing annual cash requirements to that of a chess master. Like in Chess, the process of strategic decumulation involves many moving pieces, and many specific technical rules that must be adhered to. Chess and strategic decumulation require the ability to think strategically, the need to anticipate, and the need to adapt to the unexpected. The tactics of a grand chess master is to wisely choose moves those open bigger opportunities later in the game. He/She identifies patterns as the game unfolds and then relies upon their years of experience to choose and deploy pre-determined sets of moves to respond to unwanted developments. It is a dynamic process of making the best choices at a given point in time, with the intention that the moves contemplated on the next turn may have to be amended.
Thankfully, when one chooses to employ design thinking and use Retirement Designer as your retirement navigation system, you are in fact uncovering the clues a retirement income specialist requires to build you a customized year by year draw-down recipe of where to source your needed cash flow, as it is required.