Income vs Cash Flow in Retirement
What is the difference between income and cash flow?
Cash flow and income are not the same thing, although people sometimes use the terms interchangeably. Income is new money coming to you, through work (salary or wages) or other sources (such as an employer pension or Canada Pension Plan, Old Age Security or investment dividends). Cash flow is money you have already earned (and perhaps already paid tax on) becoming available to meet your expenses.
How much cash flow do you need?
What matters in retirement is ensuring you have enough cash flow (some of which may be in the form of income) to meet your daily and long-term needs, regardless of your actual income or wealth. To do that, you must know what your expenses are. Track all your spending for a year to determine your needs, adding in new expenses anticipated during retirement (for example, more travel and healthcare spending).
Also think about your long-term goals. Do you want to leave a legacy for your family or charity, or do you want to enjoy your money to the fullest extent possible? Understanding your own feelings in this area, and discussing your plans with your financial advisor, will help you know how much to save for the long term and how much to release into cash flow, and when.
Also think about possible preconceived notions you may have about retirement spending. Some people have a very firm idea that they must never touch their principal savings and must make do with only interest and dividend income and government support. Obviously you don’t want to run out of funds, but consider whether you really need to leave your entire principal to your heirs. While there is no hard-and-fast rule for how much you can withdraw from principal each year, it certainly is possible to use your capital sustainably. Talk with your advisor about what a sensible percentage might be for your circumstances.
Tax differences
Most income is taxable when you earn it, one exception being investments you place in registered accounts. But you may be able to reduce the amount of tax you pay in retirement by strategizing how and when you receive cash flow. For example, withdrawing funds from your non-registered portfolio may allow your RRSP to continue to grow, tax-deferred. That makes sense if you are likely to be in a lower tax bracket in the future. On the other hand, taking cash flow from registered investments earlier may allow you to keep a greater portion of your Old Age Security payments later.
You will pay different tax on interest, capital gains and dividends. Generally, if you are in a lower tax bracket, dividends are more tax efficient. If you’re in a high bracket, capital gains are likely to be more efficient.
Using insurance for retirement cash flow
You may be able to use your life insurance policy to generate cash flow during retirement. One way is with a return of premiums. If you elect to reduce or discontinue certain types of coverage (such as critical illness) after you’ve held your policy for a certain time (such as 15 years) or to a specified age (such as 75) without a claim, you can get your premiums back. This type of insurance makes sense if you want to protect your family while you have dependents and major expenses, but don’t anticipate needing coverage when you’re older. You do have to select this rider when you buy your insurance, however, and be aware of what your premiums may be as you get older. And of course, understand that when you get your premiums back, your policy is no longer in force.
If you have permanent life insurance, you may consider cashing out of the policy, either fully or partially. With this strategy, you will have to pay income tax on a portion of the policy’s value; the amount of tax increases the longer you have the policy. So extracting cash from life insurance is, usually, best done earlier rather than later.
Finally, if you have maximized your tax deductions and have non-registered funds you wish to shelter, you can generate cash by arranging a bank loan using your permanent life insurance policy as collateral. The interest on the loan will be capitalized into the loan so that no payments are required. The loan amounts that are paid out yearly become tax-free cash flow.
Most people will benefit from meeting with an experienced financial advisor or tax planning expert to discuss strategies for finding the right balance for you between taking cash flow from registered and non-registered investments. A professional will be able to help you structure your cash flow to meet your long-term needs.
