Taxes and your retirement income: Key principles to consider with your advisor and tax professional

When retirees draw income in retirement, they can benefit by considering available tax strategies. This article explores some of the essential concepts for investors to consider as they work with their advisor and tax specialist: 

• Be aware of income thresholds for key government programs and tax credits (i.e., to minimize the risk of claw backs)
• Manage tax brackets
• Think long term: a small difference in tax efficiency today can make a big difference over time
• Consider the taxation of different types of income: capital gains, interest, dividends, foreign source income and Registered Retirement Savings Plan (RRSP) and Registered Retirement Income Fund (RRIF) withdrawals, etc.
• Canada Pension Plan (CPP) take-up decision
• Investment vehicles (i.e., the account types that contain your investments, such as your RRSP) and the nature of your underlying investments (for example, a corporate class mutual fund)

Let’s talk about income. Different types of income that is earned will be reported on specific line items on a Canadian’s Income Tax and Benefit Return (T1), however, there is one line, net income (line 23600), that is important to monitor.

Why is it so important to monitor income in retirement?

Management of key income thresholds

There are various tax credits and income-tested government programs that may be reduced or eliminated when a taxpayer’s net income (line 23600) or net income before adjustments (line 23400) exceeds a certain amount. We’ll focus on two pertinent items for retirees.

1. The Age Amount tax credit - this is a non-refundable tax credit. This tax credit is available to individuals who are aged 65 or older by the end of the relevant tax year. It’s calculated using the lowest tax rate (15% federally). The maximum federal credit for 2025 is $9,028 (2024 - $8,396), but is reduced by 15% when your net income (line 23600) exceeds the yearly threshold. For 2025, the income threshold is $45,522 (2024 - $42,335). The credit is eliminated when net income exceeds $105,709 (2024- $98,309).
2. The Old Age Security (OAS) claw back - generally an OAS pension is available to Canadian citizens or legal residents age 65 or older, who have lived in Canada for at least 10 years after turning 18. For 2025, the maximum OAS monthly benefit for January to March is $727.67 for an individual age 65 to 74 and it increases to $800.44 for an individual age 75 and older. The benefit can be deferred to age 70, resulting in an increase of up to 36%. Recipients must pay back all or a portion of their OAS if their annual net income before adjustments (line 23400) exceeds $93,454 in 2025 (2024 - $90,997). OAS is clawed back at a rate of 15% on net income above that amount and must be fully repaid when this net income figure exceeds $148,451 in 2025 (2024 - $142,609) for individuals age 65 to 74 and $153,771 in 2025 (2024 - $148,179) for individuals age 75 and older.

Because the age amount tax credit has a lower net income threshold, in some cases it may not be possible to retain it. However, optimization tactics should always be used when you have a spouse (or a common law partner). In the case study below, we have quantified the potential costs of these claw backs along with the cost of mismanaging tax brackets for the taxpayer.

Tax bracket management

Another reason to monitor income in retirement is to effectively manage your income relative to the various Federal and Provincial tax brackets. After all, your net income, referred to above, often equates to the taxable income figure on line 26000 on an individual’s T1, being the number on which income tax is calculated.

By managing net income, and in turn taxable income, a taxpayer can ensure that they stay within their target tax bracket, while not being subjected to needless taxation. Unnecessarily pushing taxable income beyond your target tax bracket can result in thousands of dollars of additional taxes payable each year. In retirement, this can be particularly costly given the fact that Canadians are living longer, thereby increasing the prevalence of longevity risk. Simply put, retirees don’t want to outlive their money.

Mismanagement of income thresholds and tax brackets: a case study

Assume an Ontario taxpayer has a variety of potential sources of income/cash flow but doesn’t efficiently manage their tax brackets during retirement for 2025. This results in taxable income of $93,000 for the year. For the purposes of the exercise, we’ll assume the income is fully taxable (for example, interest income or RRIF withdrawals). By breaching the top of their target tax bracket, they will be subject to a tax rate of 31.48% on their taxable income above $93,132. This results in additional personal taxes owing, not to mention a reduction in the age amount tax credit and a $473 claw back of the OAS pension benefit. In this case, it likely wasn’t realistic to retain the entire age amount tax credit, but if income was otherwise managed to remain within the identified target tax bracket, the risk of claw back of OAS would be reduced.

By managing brackets more efficiently, and strategically drawing on more tax favourable levers in retirement, the taxpayer could have avoided these results.

How to keep net income in check in retirement

How much does it cost to withdraw an additional $1 after tax? It depends on your tax bracket and the type of income. The table below shows combined Federal and Ontario income tax rates.

*Tax-Free Savings Account (TFSA); return of capital (ROC)

Source:  https://www.taxtips.ca/taxrates/on.htm

Tax efficient “levers”

Not all income is created equally for tax purposes and that’s especially crucial in retirement. In the mismanagement scenario above, we alluded to the concept of pulling cash flow from tax-efficient levers. More specifically, that could include cash flow via tax-free return of capital (ROC) or even tax-free TFSA withdrawals. Per the chart above, a $1 withdrawal will net a taxpayer $1 from either of those two levers while having zero impact on net income or taxable income, regardless of their tax bracket.

While it would be nice to only draw on tax-free sources of cash flow in retirement, this isn’t practical for most retirees. As well, there are certain minimum withdrawal requirements from a RRIF to consider. As such, it’s important to take a long-term approach in managing tax brackets and thresholds over the course of your entire retirement timeline, keeping in mind that there will likely be multiple sources of retirement income available.

Fully taxable income

Fully taxable income includes sources such as employment income, RRSP/RRIF withdrawals, pension income, rental income, interest income and foreign income. In the case study above, we assumed that the taxpayer was extracting from a fully taxable source, such as their RRSP/RRIF. As such, to net $1 in their pocket (after-tax), it was costing them $1.46 once they breached the top of their target tax bracket ($93,132). In certain instances, this outcome may be unavoidable. But, typically a more efficient alternative is available. Whether that be strategic TFSA withdrawals or income splitting with a qualifying spouse (or common law partner) at age 65 or older if a disparity in RRSP/RRIF balances or income levels exists. The name of the game is to optimize retirement income not just for the taxpayer, but for the household.

Realized capital gains & capital gains dividends/distributions

In a non-registered account, when capital gains are realized, or capital gains are distributed from an underlying mutual fund or Exchange Traded Fund (ETF), only 50% of the gains are included in net income. For example, a $1,000 capital gain results in an income inclusion of $500. This is preferable to fully taxable income, so the outcome may not be as detrimental from a tax perspective.

It's important to remember that applying capital losses from prior years against capital gains in the current year reduces taxable income (line 26000) but doesn’t reduce net income (line 23600). This is a common oversight in planning and can lead to unexpected claw backs.

Eligible dividends

These dividends are typically received from publicly traded Canadian corporations. They are grossed up 38% when calculating net income. For example, a $1,000 dividend received results in an income inclusion of $1,380. This doesn’t mean you’ll pay more tax though. With a generous dividend tax credit, the tax cost of eligible dividends is lower than fully taxable amounts, such as employment income or an RRSP withdrawal.

Where the 38% gross up can be an issue is with respect to income tested benefits. Let’s assume a taxpayer has $80,000 in net income, with some coming from OAS. They then receive a $10,000 eligible dividend from a publicly traded Canadian corporation. With the gross up, the taxpayer’s income increases to $93,800, which puts them above the OAS claw back threshold of $93,454 for 2025. As noted above, OAS payments will be repaid or reduced next year by 15 cents for every dollar earned above the threshold.

Overall, while it can be cheaper from an income tax perspective to get that additional $1 after-tax, the true cost of those additional potential claw backs must be considered. If a taxpayer is comfortably within their target brackets, and/or thresholds, eligible dividends in a non-registered environment can be very attractive from an income tax standpoint.

Ineligible dividends

These dividends are typically received from Canadian Controlled Private Corporations (CCPCs). They are grossed up at 15% for the purposes of calculating net income, but the tax credit isn’t quite as attractive as with eligible dividends. This type of income typically forms a large part of a private business owner’s retirement income plan.

As with eligible dividends, the gross up could affect income tested government benefits.

Government pensions

Like OAS, CPP retirement income is fully taxable, and the benefit can also be deferred until age 70. In some scenarios, this deferral can be attractive, especially considering the degree to which this lifetime guaranteed income will be enhanced. For an individual deferring their CPP income from age 65 to 70, their benefit increases by 42% plus indexation. This can be an attractive option for a conservative investor who maintains adequate assets to bridge their income throughout the deferral period, while maintaining confidence they will live to, and/or potentially beyond typical life expectancy.

Spouses and common law partners should consider the potential tax advantages associated with  CPP sharing in addition to the timing of receipt of their CPP in retirement. Where CPP entitlement and other sources of income in retirement differ, this may be to a couples’ advantage from an income tax and cashflow perspective.

Appropriate investment vehicles

Investors have two things to consider in making tax-effective decisions: the choice of specific investments and the vehicles that hold those investments. For example, using non-registered funds to purchase an annuity that qualifies for preferential prescribed tax treatment would be more tax-efficient than if that same annuity were purchased within an RRSP.

Often, retirees want foreign exposure (which includes the U.S.) in addition to conservative, fixed income investments. Unfortunately, the income generated by these types of investments is generally inefficient from a tax standpoint – that is, it’s taxed like interest and employment income, but a foreign tax credit may serve to reduce the amount of tax payable.

One option that enables a retiree to gain foreign exposure, while mitigating the negative tax consequences, is a corporate class mutual fund. For non-registered portfolio holdings, this structure may be attractive, as it will typically distribute tax-preferred dividends. Fully taxed interest and foreign income are, thus, avoided. Typically, the distributions are lower (than a comparable mutual fund trust or ETF) and compound growth is potentially enhanced as a result.

Corporate class funds can enable investors to better manage tax brackets while optimizing net income in the face of potential claw backs. Consider this positive impact in conjunction with exposure to eligible dividend income and the resulting gross-up, depending on the underlying fund of choice.

A smooth, consistent approach

Retirement income planning is a marathon, so a consistent approach can smooth income over the course of retirement, while maintaining flexibility. Consider the implications of where assets are held, where they are drawn from and the ripple effects of each decision on net income before adjustments, net income for tax purposes and taxable income. This planning is complex, and often requires working with a qualified tax professional.