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Canada Revenue Agency: How to Build a Tax-Free Pension

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Old Age Security (OAS) and Canada Pension Plan (CPP) pensions might not pay enough to support a comfortable lifestyle in retirement.

OAS rules

OAS is available to Canadian citizens or legal residents that are at least 65 years old.

To qualify, you must have resided in Canada for at least 10 years since the age of 18. That jumps to 20 years for people living outside the country.

To get the full OAS pension, you need to reside in Canada for at least 40 years after age 18. If you are 65 years old but do not qualify for the full pension, you can get the partial OAS pension. The CRA gives you 1/40th of the OAS for each year you lived in Canada after the age of 18. Applicants still need to meet the minimum 10-year requirement, so the lowest OAS would be 25% of the full amount.

Since 2013, retirees can defer the start of their OAS pension payments for up to five years. The OAS pension increases by 0.6 for each month you delay receiving the pension. The maximum monthly OAS amount for someone age 65 in 2020 is currently $613.53. OAS payments are considered taxable income.

Special note: The CRA implements a clawback on OAS pension payments when your net world income tops a minimum threshold.

CPP rules

The Canada Pension Plan (CPP) amount is based on your average earnings through your working life, CPP contributions, and the age you decide to start receiving the CPP pension.

The CPP is available as early as age 60, although you get a reduced amount from each year you take the CPP before age 65. As with OAS, you can get a higher payment by deferring the CPP up to age 70.

The maximum monthly CPP amount for someone starting at age 65 in 2020 is $1,154.58. CPP payments are considered taxable income.

Other taxable retirement pension income would include money from RRSPs or RRIFs.

How to create a tax-free pension

People that spent several years outside of Canada might not qualify for maximum OAS or CPP benefits. In this case, using the TFSA to build a self-directed pension might also be attractive.

At the same time, people who earn too much money in retirement might want to avoid or minimize OAS clawbacks by generating income out of a Tax-Free Savings Account (TFSA).

What are the best investments?

GICs are safe, but they don’t pay much these days. Bonds have rallied to the point where they also offer very low yield to maturity.

As a result, dividend stocks might be the best way to go. The TFSA contribution limit is as high as $69,500 in 2020, so people have decent room to build a portfolio.

A balanced fund of high-quality companies with reliable payouts could easily provide an average yield of 5-6% today. Stocks that might be interesting picks to get started include Royal Bank, BCE, TC Energy, Manulife Financial, and Fortis.

Royal Bank is Canada’s largest bank by market capitalization and offers a yield of 4.6%.

BCE is Canada’s largest communications provider. The dividend yield now sits at 5.9%.

TC Energy is a leading player in the North American natural gas transmission sector. Investors can pick up a 5.6% yield right now.

Manulife is a Canadian insurance and wealth management firm with operations around the globe. The stock’s dividend provides a yield of 6%.

Fortis is a utility company with $57 billion in assets located in Canada, the United States, and the Caribbean. The board has raised the dividend in each of the past 46 years. The current payout provides a yield of 3.6%.

The bottom line

Retirement income comes from a variety of sources. Ensuring as much as possible remains tax-free is part of the overall pension strategy.

Whether you want to avoid OAS clawbacks or don’t think you will have enough income from OAS and CPP pensions, it makes sense to use the TFSA to create a tax-free income fund.

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