How do I avoid Old Age Security clawbacks due to high dividends?

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By Julie Cazzin with Allan Norman

Q: My wife and I are 83 and 80, respectively, and I am losing my Old Age Security (OAS) due to dividends and my registered retirement income fund (RRIF) withdrawals. I wish when I was younger that someone had told me dividends could be a problem as a retiree. I am thinking of cashing out my RRIF this year and cashing in my stocks for index funds so I can collect my OAS pension. Does this make sense? Our tax-free savings accounts (TFSAs) are maximized, I have $600,000 in RRIFs as well as a pension of $45,000 per year, and my wife has $490,000 in a RIFF. We have non-registered investments of about $3.5 million with a dividend yield of about 3.2 per cent, and a small rental in my wife’s name with an income of $9,000 per year. — Tim

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FP Answers: You are in a good spot, Tim, and it is smart to think about how to minimize your taxable income to reduce OAS clawbacks, which apply if your net income exceeds $90,997 in 2024. And you will have to repay 15 per cent of the excess over this amount to a maximum of the total amount of OAS received. Just be careful that you don’t do something that will cost you more money in the long run.

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Don’t beat yourself up about dividend investing. If, when you were young, you were advised that future dividends may result in OAS clawbacks, you may not have the money you have today. Dividend investing is a comparatively easy stock selection strategy, making it popular with DIY investors. That, plus the fact that value stocks — often dividend payers — have historically outperformed growth stocks.

Today, your stocks are producing a steady flow of taxable dividends that you are reporting on your tax return. However, you must report the grossed-up (38 per cent) dividends, not the actual amount of dividends received. For example, if you receive $100,000 in dividends, you report $138,000, which is the number used to assess OAS clawbacks. After the clawback assessment, the dividend tax credit is applied, bringing down your taxable income.

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Dividends are one tax issue in a non-registered account. Capital gains, which are the difference between the book and market value of an asset such as stocks or investment real estate, are the other tax issue, and they will also impact your OAS eligibility.

The challenge with holding individual stocks in a non-registered account is the tax drag (the reduction in potential income or growth due to taxes on investment gains) created by dividends and capital gains when trading stocks.

My guess is you are thinking of switching to index funds because they tend to be more tax efficient, are longer-term holds and, according to the SPIVA reports — which compare returns from active equity and fixed-income mutual funds and their benchmarks — are more likely to outperform managed portfolios.

When it comes to RRIFs, I often suggest to people starting retirement not to draw more than needed unless the excess is going into another tax shelter such as a TFSA. The reason for this is because of the tax drag I described above.

If you draw excess money from your RRIF, you pay tax and have less money to reinvest. In your case, Tim, that amounts to about 40 per cent less or even more, depending on the amount you draw from your RRIF. You are also subject to the tax drag of dividends and capital gains when you invest in a non-registered account.

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Having said that, as you draw closer to the end of your life, there is a tipping point when it begins to make sense to draw from your RRIF and invest in a non-registered account. In the year of your death, your marginal tax rate (in Ontario) will be 53.53 per cent. If you can draw money from your RRIF at a lower tax rate in the year prior to your death, that is better than leaving it all to the end when it is taxed at a higher rate.

Just like the younger retiree withdrawing excess from their RRIF, you are still faced with less money to invest and a tax drag. The difference, using the example above, is that there is only one year of the tax drag, and if you had left the money in the RRIF, only one year for the tax-deferred growth to make up for the larger tax rate in the final year.

I was curious to see what would happen if you withdrew all your RRIF money now at age 83, or enough each year to deplete it by age 90, compared to leaving it all until age 90. I found that in both cases, using age 83 as your tipping point, you are better off not withdrawing excess money from your RRIF.

There is, however, an advantage if you withdraw money from your RRIF and gift it to your children. I found the biggest gain, as measured by the total wealth transfer to your children, came when you withdrew everything from your RRIF in one shot rather than depleting it over seven years. Of course, the total gain will depend on what and how your children invest the money.

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Have you thought about charitable contributions? In combination with excess RRIF withdrawals, or on its own, you could donate some of your stocks with large capital gains to a charity. By doing this, you avoid the capital gains tax, thereby giving you more money to invest and a larger charitable tax credit.

Tim, with the assets you have, I don’t see you escaping the OAS clawback unless you perhaps withdraw everything from your RRIF now and donate all your non-registered investments to a charity. If it makes you feel any better, it is the after-tax OAS amount you are not receiving.

Allan Norman, M.Sc., CFP, CIM, provides fee-only certified financial planning services and insurance products through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Canadian Investment Regulatory Organization. Allan can be reached at [email protected].

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