Tax Planning for Investors in or near Retirement: Age Credits and OAS Clawbacks

Many if not most investors are aware of the fact that eligible Canadian dividends held in a non-registered taxable account are grossed up before inclusion in income. From 2012 onwards, the gross-up on the actual dividend paid has been 38%. There is a sufficiently large offsetting tax credit such that the investor pays a lot less tax on dividends than on interest or employment income (see our post on how the mechanics and reality of dividend taxes work).

But there is a complication for someone over 65 in retirement. The Old Age Security Pension (OAS), an amount up to $6582 paid annually to over 65s meeting Canadian residency requirements (see TaxTips.ca's explanation and Government of Canada info) and the Age Amount tax credit, worth up to $1028 reduction in tax, are progressively reduced the higher is Net Income on line 236 of a tax return. Thus, $1000 of actual dividends is grossed up 38% to $1380, and the dividend tax credit only gets applied lower down in the tax form. Line 236 includes the grossed-up amount of dividends. The gross-up acts as a penalty. Other types of income, like interest and foreign dividends are not grossed up while only half of actual capital gains are included in income of line 236.

Retired investors, or those soon looking to retire, may wonder if they should dump their Canadian dividend stocks and instead buy foreign stocks (whose dividends are not eligible for the tax credit and do not therefore get grossed-up) or perhaps buy interest generating fixed income in a taxable account. Let's address this question.

TaxTips.ca's handy-dandy calculator

We have used the Investment Income Tax Calculator on Taxtips.ca to demonstrate what is a very simple conclusion - dividends are tax-advantaged enough that they are still better than interest or foreign dividend income no matter the province or your tax bracket. There is a loss of Age credit and/or OAS but much less than the extra income tax on interest or foreign income. However, capital gains are almost always the best way to receive income, if that is possible.

We entered the 2013 maximum amounts of CPP and OAS along with combinations of either interest and/or foreign income, which are both taxed at the highest marginal rate of Other Income, or capital gains, or eligible Canadian dividends, plus withdrawals from a RRIF or other pension plan income.

Scenario 1 - Income high enough to trigger reduction in the Age amount tax credit - $51,732

Capital gains and dividends give pretty close results but interest and foreign income incurs significantly more tax. In Alberta, at these more modest income levels, eligible dividends win by a hair.

Scenario 2 - Income that triggers both an Age amount tax credit reduction and OAS clawback - $73,732

Capital gains clearly is best while interest and foreign dividends engender even more tax. The pattern is the same across all provinces.

Scenario 3 - Income high enough to trigger large OAS clawback - $93,732

The bottom line is the same as scenario 2.

Takeaways

• There is no tax reason to alter a retirement portfolio away from Canadian equities because of Age Amount tax credit reduction or OAS clawback. If anything the reverse is true. Portfolio asset allocation and account placement of holdings do not need to change.
• The conclusions we reached a few years back about the desirability of dividends and capital gains across provinces hold true for retired investors. As the years are passing and TFSA accounts grow larger with piling up the yearly contributions (there is $5500 contribution room again this year bringing the total since 2009 to $31,000), they can form a significant component of tax planning during withdrawal since any TFSA withdrawal doesn't enter taxable income at all.
• Some ETFs that are highly tax efficient may be especially attractive to retired investors, though we found out last year that the best type of distribution in tax terms, Return of Capital which doesn't get included in immediate income and is deferred capital gain, may not be so good in certain ETFs.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.