Pre-Retirement Withdrawals

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					Pre-Retirement RRSP Withdrawals


 Amin Mawani – York University
 Suzanne Paquette – Laval University

       amawani@schulich.yorku.ca
RRSPs
   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)

                                               2
    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  contribute once withdrawn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
  accomplished
 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
  expenses
 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

                                          8
    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
       40
       35
                       34.46     35.72        35.73      34.9      34.28
       30   33.58
       25
Rate




       20
       15
       10              4.67      4.95          5.28      5.54      6.09
             4.3
       5
                3.25      3.28         3.26       3.21      3.02      3.25
       0
            1998       1999      2000       2001         2002      2003
                                         Year
        Contributions rate                    Withdrawals rate (incl. HBP)
        Withdrawals rate (excl. HBP)
                                                                             13
Trends in RRSP contributions and
withdrawals: 1998-2003




                                   14
 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
Statistics
 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
                       holders)
Including   22,740      8.35 %       $4,700        $1,400        11.4%
HBP
shortfall
Excluding   14,880      5.62%        $6,600        $3,000        15.8%
HBP
shortfall


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




                                                                            17
Limited investments outside RRSPs

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


                          P

               R

                    NR
    RRSP withdrawals
 Since many Canadians do not have any
  significant investments outside their
  RRSPs and principal residences, RRSP
  withdrawals may be necessary to smooth
  consumption
 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
  consumed?
 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)


                                                22
    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
      owners
                                                 23
Utility for Smooth Consumption
 What drives withdrawals?
                           Need for Income

                         High             Low



                            A               B
   Price     High   (income effects   (withdrawals
    Of                   alone)        irrational)
Withdrawal
(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

                                            28
Data
   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


                                                 29
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)


                                           30
    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
                                             35
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


                                            36
After-Tax Accumulation per Dollar
invested @7% with t0=46%; tn=33%
                                         After Tax Accumulation
                                            per Dollar Invested


                  6.00



                  5.00



                  4.00
   Accumulation




                  3.00



                  2.00



                  1.00



                  0.00
                         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

       amawani@schulich.yorku.ca