Pre-Retirement Withdrawals by wuyunqing


									Pre-Retirement RRSP Withdrawals

 Amin Mawani – York University
 Suzanne Paquette – Laval University
   Tax-preferred savings
    – Intended mainly for retirement savings
    – However may be used for short-term
      precautionary savings or income smoothing
    – Contributions deductible for tax
    – Investment income grows tax-free
    – Withdrawals fully taxable (but no penalty)
    – Temporary tax-free withdrawals for
       • Home buyer’s plan (HBP)
       • Lifelong learning plan (LLP)

    RRSP features
 Main attraction is the tax-free compounding
 Early (pre-retirement) withdrawals cannot be
  replaced – unlike TFSAs
 Pre-retirement withdrawals can significantly
  impair long-term accumulation necessary to
  fund retirement
 Retired phase becoming increasingly longer
 & potentially more expensive due to
  higher out-of-pocket health care costs
    Cost of foregone tax revenues
   RRSPs estimated to cost Canadian
    government $12.125 billion in 2010

   Foregone US tax revenues for 2006:
    – $104.3 billion for employer-provided plans
    – $11.2 billion for traditional IRAs
    – $9.4 billion for self-employed pension plans
    – $125 billion in total foregone tax revenues
    RRSP Restrictions
 Opportunity cost arising from inability to re-
  contribute once withdrawn
 No additional penalties for early withdrawal
  in Canada, thereby allowing flexibility to
  choose retirement dates
 Few restrictions on types of investments
 HBP and LLP allow competing investments
  in housing and human capital so as to not
  constrain investment and consumption
  choice over what is typically a long horizon
    Government policy
 While governments may not object to
  taxpayers holding their short-term
  precautionary savings inside RRSPs,
  they remain concerned that their policy
  goal to make Canadians self-sufficient
  during retirement may not be
 Governments should be concerned if less
  sophisticated taxpayers are reducing
  their retirement savings by withdrawing
  during periods of high tax rates
    Recent trends in Canada and the US
 Increasing # of individuals and families
  are experiencing income shocks and / or
  higher variance of earnings
 Resulting in greater number tapping into
  their retirement savings before retirement
  to finance current consumption
 Pre-retirement withdrawals more
  prevalent among income groups that can
  least likely to afford eroding their
  retirement savings
 Prior Research
 Scotiabank Survey (2007): 40% of
  Canadians withdrew $ from their RRSPs
  to invest in homes (renos), pay down
  their mortgages & even cover living
 Variance of earnings has been increasing
  over time: highs are higher & lows lower
 1 in 5 families has experienced at least 1
  year of low income during last 8 years

    US rules
 10% penalty on early withdrawals except if
  needed for medical, tuition and first home
 Individuals owning 401(k) plans can borrow
  up to half their retirement savings at a
  reduced interest cost for any reason as long
  as they are repaid within 5 years
 Cost of withdrawals = repayment of interest
  on borrowed funds with after-tax dollars +
  10% penalty if not repaid within 5 years
    US trends
   Such loans against retirement savings
    have grown by about 400% (inflation-
    adjusted) for the middle class alone
    – From $6 billion in 1989 to $31 billion in 2004
   Withdrawals were consumed, not invested
    – Borrowers from 401(k) plans spent a median
      of 22.5% of their incomes for debt repayment
    – Non-borrowers spent 18% (1995-2004)
    – This difference of 4.5% during 1995-2004 is
      up from 0.6% during 1989-1995
RRSP / IRA used for short-term
 Waterloo co-op students studying and
  working alternate terms – may use
  RRSPs to smooth after-tax income
 Increasing generosity of unemployment
  insurance benefits crowds out 401(k)
  contributions by younger workers who
  seem to save for short-term
  precautionary reasons - Love (2006)
    RRSP Trends
   Grown from 2% of household assets in 1977 to
    more than 12% in 1999
    – May slow down with new TFSAs on the market
 Growth due to broader participation rather than
  larger contributions
 75% of RRSP owners in our sample had used
  up less than 80% of their cumulative RRSP
  contribution room
 34.8% of taxpayers contributed an average of
  $4,100 during 1998-2003
 Median contribution = $2,450 (1998-2003)
       Trends in RRSP contributions and
       withdrawals: 1998-2003
                       34.46     35.72        35.73      34.9      34.28
       30   33.58

       10              4.67      4.95          5.28      5.54      6.09
                3.25      3.28         3.26       3.21      3.02      3.25
            1998       1999      2000       2001         2002      2003
        Contributions rate                    Withdrawals rate (incl. HBP)
        Withdrawals rate (excl. HBP)
Trends in RRSP contributions and
withdrawals: 1998-2003

 Descriptive Statistics: 1998-2003
   Year       Contributions          Withdrawals           Withdrawals
                                    including HBP         excluding HBP
                                       shortfall             shortfall
        Rate            Mean        Rate      Mean        Rate      Mean
   1998 33.58           $4100       4.30      $4900       3.25      $6100
   1999 34.46           $4200       4.67      $4600       3.28      $6100
   2000 35.72           $4300       4.95      $4500       3.26      $6300
   2001 35.73           $4100       5.28      $4000       3.21      $5900
   2002 34.90           $4000       5.54      $3600       3.02      $5800
   2003 34.28           $3900       6.09      $3300       3.25      $5300
   mean 34.78           $4100       5.14      $4150       3.40      $5917

Population: All tax-filers resident in Quebec in the 20-59 age group and
receiving no pension income
 8.35% of plan-holders withdrew an
  average of $4700 from RRSPs in 2000,
  representing 11.4% of annual income
 5.62% of plan-holders withdrew an
  average of $6,600 for reasons other
  than HBP, representing 15.8% of
  annual income
 HBP is the single biggest reason for
  withdrawing (by missing repayments)
Descriptive Statistics (2000)

               N      Withdrawal       Mean       Median       Withdrawal
                         rate       withdrawal   withdrawal     amount /
                      (% of plan-    amount       amount         income
Including   22,740      8.35 %       $4,700        $1,400        11.4%
Excluding   14,880      5.62%        $6,600        $3,000        15.8%

HBP is the single biggest reason for withdrawing (by missing repayments)

Limited investments outside RRSPs

 P = Portfolio; R = Registered Portfolio
 NR = Non-registered Portfolio
   Average investment income outside RRSP = $1,400



    RRSP withdrawals
 Since many Canadians do not have any
  significant investments outside their
  RRSPs and principal residences, RRSP
  withdrawals may be necessary to smooth
 May not signify poor financial planning
 Major cost is the loss of pre-tax
  compounding of annual investment
  returns, with the cost being larger for
  younger taxpayers having longer
  investment horizons
    Withdrawal trend increasing
 The young withdraw more often – by missing
  their HBP repayments, by becoming unemployed,
  by stopping work to have children,…
 The opportunity cost of sheltered returns may be
  perceived to be small given that most taxpayers
  have significant unused RRSP contribution room
 CAUTION: RRSP owners may withdraw more
  thinking that they can always re-contribute to new
  TFSAs which are equivalently tax-sheltered
    Are withdrawals being timed right?

 Higher tax rates make withdrawals costlier
  (Price Effect)
 Lower incomes make withdrawals more
  likely (Income Effect)
 Are withdrawals being reinvested or
 Can sound financial planning help?
Withdrawals not necessarily bad if
   Used to reinvest in higher yielding
    investments such as mortgage (HBP) or
    human capital (LLP)
    – RRSPs, personal mortgages and
      investments in human capital all yield tax-
      exempt returns
    – HBP found to be beneficial for taxpayers –
      Donnelly et al (Canadian Tax Journal 1993)

    Motivations for Withdrawals
   Better investment returns elsewhere
    – consistent with maximizing retirement savings

   Tax planning by shifting income from high
    tax rate periods to low tax rate periods

   Smoothing consumption to override shocks
    – Precautionary savings held inside RRSPs
    – Non-RRSP assets minimal for most RRSP
Utility for Smooth Consumption
 What drives withdrawals?
                           Need for Income

                         High             Low

                            A               B
   Price     High   (income effects   (withdrawals
    Of                   alone)        irrational)
(Tax Rate)
                           C                 D
             Low     (withdrawals     (price effects
                       rational)          alone)
    HBP Participants have…
   Higher marginal tax rates (0.41 vs. 0.40)
   Lower individual incomes ($40,000 vs. 42,200)
   Lower couple incomes ($64,800 vs. $68,500)
   Lower individual investment income (590 v 1,500)
   Lower couple investment income (1,000 v 2,700)
   Greater variability of income at couple level
    – Perhaps having children with one parent on maternity
 More unused contribution room
 Are younger in age (36.8 years vs. 42.4 years)
 Are more likely to have young children
    HBP Participants & Clawbacks
   Missed HBP repayments is the single biggest
    form of withdrawal
    – 13.1% of our sample but 40% of withdrawers
 Recipients of child tax benefits are subject to
  clawbacks that can increase their tax rates
 Plan-holders may not know their marginal tax rate
    – Complicated due to clawbacks triggered by incomes
      of different tax periods
    – Confirmed by survey evidence
    – Need to improve financial literacy
    – Need previous year’s tax software for tax planning and
      not current year’s tax software for tax compliance
      Research Objectives
(1)   Examine frequency & magnitude of pre-
      retirement withdrawals (1998-2003)

(2) Examine income shocks, demographic &
    tax factors associated with withdrawals

(3) Assess whether withdrawal decisions
    associated with shocks at individual level
    or household (couple) level

   Stats Canada / CRA data meeting
    the following criteria:
    – Québec resident
    – Québec resident taxpayer having filed a
      return for all years 1996 – 2000
    – No pension income during same period
    – Aged between 24 and 59 in 2000
    – RRSP owner in 2000
    – Federal tax > $1 and provincial tax > $1

We investigate two models
Model I: Probability of withdrawal

Model II: Withdrawal amount

   Differences in results from the above
    two models suggest amount withdrawn
    is not linearly associated with need for
    income or price of withdrawal (tax rate)

    Results: Price & Income Effects

 Both Income and Price effects strongly
  associated with RRSP withdrawals
 “as if” TAX RATE and “as if” INCOME –
  i.e., tax rate or income before withdrawal
 Variability of Income strongly associated
  with pre-retirement withdrawals
   – higher uncertainty in the future likely to
     increase withdrawals
    Timing & frequency of withdrawals
 Withdrawals generally timed right in terms
  of tax planning – but not always
 Need for income more important than the
  price of withdrawal (i.e., tax rate at the time
  of withdrawal)
 Changes in income (income shocks) more
  important than levels of income
 Tax rates (price effect) important in the
  decision to withdraw, but not on how much
  to withdraw
    – Driven in part by HBP participants who make
      all-or-nothing decisions about repayment
Pre-retirement withdrawals higher for
 Plan-holders with negative income shocks
 Plan-holders with low investment income
  (both at the individual and couple level)
 Plan-holders with low marginal tax rates
 Plan-holders with recent job loss, divorce,
  separation, widowhood or disability
 Plan-holders with more volatile income
 Plan-holders with Home Buyers Plan
    – Missed payments at an inopportune time
Pre-retirement withdrawals lower for
 Persistent contributors (perhaps because
  they manage uncertainty better)
 Plan-holders with lower unused contribution
  room (i.e., a feasible / realistic retirement
  plan helps plan-holder to stay on track)
 Self-employed
 Female (manage uncertainty better)
 Recent immigrants
    Tax Free Savings Accounts
   TFSAs
    – Contributions not deductible
    – Income earned tax-exempt
    – Withdrawals not taxable
 Individuals withdrawing in high tax rate
  periods may find TFSAs better even if
  RRSPs yield higher after-tax returns
 Avoid clawbacks of benefits at high
  marginal tax rates at time of withdrawal
 Smooth consumption prior to retirement
TFSAs may substitute for both
RRSPs and non-RRSPs
 o Our research justifies a role for both
   RRSP and non-RRSP savings even for
   individuals with limited savings
  RRSPs minimize PV of tax payments
  Non-RRSPs optimize consumption
   smoothing and bequests
  TFSAs can accomplish all of the above

After-Tax Accumulation per Dollar
invested @7% with t0=46%; tn=33%
                                         After Tax Accumulation
                                            per Dollar Invested







                         1   3   5   7         9            11       13   15   17   19
                                                   Number of years
Implications for Financial Planners
 Don’t overlook RRSPs as a source of funds
  especially if withdrawals reinvested elsewhere
  more productively
 If mortgage rate (m) > interest on RRSPs (r),
  then may be (?) worthwhile to withdraw (miss
  HBP repayments) and pay tax at marginal rates
    – Not dependent on growth in house prices
 Similarly if return on human capital is > than r
 Software should incorporate RRSPs as a
  potential source of funds and their multi-period
  cost over a long horizon
Implications for financial planners
   Pre-retirement withdrawals becoming more
    widespread and material (as a % of income)
    – Try and time it right
   Make sure your clients know their
    – marginal tax rates (and therefore the price of
      earning or reporting additional income)
    – The difference between switching from one
      investment to another inside an RRSP vs.
      switching from RRSP umbrella to non-RRSP
    – After-tax balance sheets
   Make sure you know where the clients got
    their money for this “amazing investment”
Questions / Comments?

Amin Mawani, MA, LL.M, PhD, FCMA, CFP

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