Whether you are just beginning to save for retirement or are nearing the finish line, a registered retirement savings plan (RRSP) will likely play a key role. This Canadian tax-sheltered account has been central to retirement planning for decades and remains an important tool for managing retirement income and taxes.
Even if you already know the basics of RRSPs, there are important details and recent trends to consider. One of the most significant changes is longer life expectancy: people are living longer than earlier generations, which creates the need for retirement savings and income strategies that can last for a longer retirement period.
At the same time, new financial products and strategies have emerged to help investors meet that challenge while managing taxes efficiently.
RRSPs and tax considerations
RRSPs are primarily valued for tax deferral: investments grow tax-free inside the account and are taxed only when withdrawn. Ideally withdrawals occur in retirement, when your taxable income—and therefore your marginal tax rate—may be lower. Contributions to an RRSP also reduce your taxable income in the year you contribute, providing an immediate tax benefit.
A key planning question is how much of your portfolio’s future growth you want inside an RRSP. You can contribute to an RRSP only until December 31 of the year you turn 71. At that time you must choose among three options: cash out the plan, purchase an annuity, or convert the RRSP into a registered retirement income fund (RRIF).
With a RRIF you must take minimum annual withdrawals based on your age. If your RRSP assets have grown significantly, those required withdrawals could push you into higher marginal tax rates.
Because of that tax effect, many advisers suggest keeping high-growth investments in a tax-free savings account (TFSA) when possible. Investment growth inside a TFSA is never subject to tax—no income tax and no capital gains tax—making it well-suited for assets with strong growth potential, such as equities or higher-yield investments. TFSAs are also flexible for short- and long-term goals: withdrawals don’t increase your taxable income and you can recontribute withdrawn amounts in future years within the annual contribution limits ($6,500 in 2023).
By contrast, RRSP withdrawals are subject to withholding tax and must be reported as income, which can increase total taxes payable depending on your other income sources. There are exceptions for specific programs—such as arrangements for buying a home or paying for education—but generally RRSP withdrawals reduce taxable income room.
Making retirement savings last
When retirement begins, the priority shifts to generating reliable income from savings. A growing challenge for today’s retirees is the steady decline of employer-sponsored defined-benefit pensions: recent research indicates that about 90% of private-sector employees in Canada no longer have access to such pensions. At the same time, increased life expectancy complicates retirement planning—the average 65-year-old in 2018 had a life expectancy of about 86, which is several years longer than previous decades.
Strategies to extend retirement income include buying annuities, which provide guaranteed lifetime income, or constructing a portfolio of income-generating assets such as dividend-paying stocks. Annuities transfer longevity risk to an insurer but historically fell out of favour when interest rates were low. Dividend-focused portfolios can deliver cash flow but may have tax drawbacks: dividends from foreign companies are taxed unfavourably in non-registered accounts, and foreign dividends (except U.S.) can be subject to withholding taxes even inside an RRSP. Canadian dividends receive preferential tax treatment in non-registered accounts and avoid withholding tax inside an RRSP, so tax implications should guide where you hold different kinds of assets.
Tax-efficient investing with call option ETFs
To address both income needs and tax efficiency, some investment managers have developed strategies that combine dividend income with options-based overlays. One common approach is the covered-call strategy, packaged in exchange-traded funds (ETFs) that seek to generate regular income while managing tax treatment.
How call option ETFs work
In covered-call ETFs, fund managers typically hold a portfolio of large-cap, dividend-paying stocks and sell—also called “writing”—call option contracts on portions of those holdings. A call option gives the buyer the right, but not the obligation, to purchase a specific number of shares at a predetermined price (the “strike price”) before or on a specified date. The buyer pays a premium for that option in anticipation the stock price will rise above the strike price.
If the stock price remains below the strike price, the buyer usually won’t exercise the option, and the seller (the fund) keeps the premium while retaining ownership of the shares. If the stock rises above the strike price and the option is exercised, the fund sells the shares at the agreed price and also keeps the option premium—generating additional income but potentially limiting further capital upside.
Critics note that covered-call strategies can cap capital appreciation because selling calls transfers some upside to option buyers. However, for income-oriented investors—especially those focused on regular cash flow and tax efficiency—the trade-off can be attractive.
One tax advantage of certain covered-call ETFs is that a portion of their distributions may be treated as capital gains rather than ordinary income when held in a non-registered account. Capital gains are taxed more favourably—only half of capital gains are included in taxable income—so this treatment can increase after-tax income compared with typical dividend income. In registered accounts such as RRSPs, income and gains from covered-call strategies are tax-deferred and, in many cases, do not incur withholding tax.
Further reading on retirement planning:
- What does high inflation mean for your retirement savings?
- How to pick the right ETF for your needs
- TFSA contribution room calculator
- A strategy for non-registered and TFSA accounts in retirement
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This article is a paid post produced by MoneySense and may highlight a client’s product or service. It is intended to inform readers about investment strategies and products, and was prepared with assigned contributors under editorial oversight.