What Are OAS Clawbacks? How Can You Avoid Them?

What are OAS clawbacks? How can you avoid them? How impactful are OAS clawbacks in retirement?

The typical retiree will receive an OAS benefit of $7,362 per year (in 2020) and over the course of a 30-year retirement would receive payments of $220,860 (in today’s dollars). That is a significant amount of retirement income!

OAS clawbacks can reduce this income all the way to zero. OAS clawbacks are 15% of net income, so they can have a big influence on a retirement plan. Experiencing full OAS clawbacks would mean that a retiree needs to make up this income on their own through extra investment assets. This may require hundreds of thousands in extra investment assets.

Avoiding OAS clawbacks is an important part of retirement planning. We’d like to avoid these clawbacks if possible. Through various strategies we can reduce or eliminate these clawbacks in retirement. This can be very beneficial to a retiree.

There are a few strategies that can help retirees avoid OAS clawbacks. Which strategy makes sense will depend on the retirees sources of income and their financial assets. In this post we’ve got 7 strategies to consider if you want to avoid OAS clawbacks in retirement.

But first, what is an OAS clawback?

What Is An OAS Clawback?

Old Age Security (OAS) is a type of government pension which most people in Canada are eligible to receive in retirement. Unlike the Canada Pension Plan (CPP), the OAS pension is non-contributory, and it is paid out of general government revenue.

So unlike CPP, which actuaries know is well funded through contributions and investment assets for the foreseeable future, the OAS pension is a bit less certain because it’s paid out of general government revenue/taxes each year.

OAS can start as early as age 65 or can be delayed as late as age 70. Delaying OAS increases the annual benefit by 0.6% for each month of delay. Delay OAS by 1-year will increase the benefit by 7.2%.

If someone decided to delay OAS by 5-years and start their OAS benefit at age 70, they could expect to receive up to 36% more than if they started it at age 65.

To be eligible to receive OAS, a person must have lived in Canada as a permanent resident or citizen for at least 40 years following the age of 18 (you can receive partial OAS if it’s been at least 10 years following the age of 18).

OAS is an individual benefit and is not impacted by a spouse/partner/family.

OAS benefits also have a “clawback”. Officially this is known as the “OAS Recovery Tax”. The clawback on OAS benefits is meant to reduce this benefit for higher income retirees.

Because OAS is an individual benefit, it is not impacted by family income, but instead is clawed back based on individual taxable income (line 236 of your tax return). Once individual income crosses a threshold ($79,054 in 2020), OAS benefits are reduced by 15% for each extra dollar of income.

This means an income of $80,054 (+$1,000 above the threshold), would experience an OAS clawback of $150 per year. This 15% clawback works like a tax rate. The more income a retiree earns above the threshold, the more their OAS benefit will be clawed back. With a high enough income a retiree may not receive any OAS benefit at all.

Because OAS is a taxable benefit, the after tax effect of the clawback is actually less than 15%. In the example above, the $150 reduction in OAS also means there is $150 less income and therefore less tax as well. So if we use Ontario as an example, with a marginal income tax rate of 31.48% at this income level, the after tax impact of the OAS clawback isn’t 15% but actually 10.28%. Still not good, but not as bad as 15%.

So in this example, the marginal effective tax rate (METR) for this retiree is 41.76% (31.48% + 10.28%). The METR is the combination of income tax and government clawback rates. The addition of the OAS clawback can make this combination quite high so we’d like to avoid these OAS clawbacks if possible.

Strategies to Avoid OAS Clawbacks

There are a few strategies that can be used to reduce or avoid OAS clawbacks for higher income retirees…

1. Defer OAS

Sometimes deferring OAS until you are 70 can help a retiree receive at least some OAS benefit. By delaying OAS until age 70 a retiree will receive a 36% boost to their annual benefit from $7,362 to a maximum of $10,013 per year (in 2020). This also means that they can earn more income in retirement before seeing their OAS benefit clawed back entirely. Someone who takes OAS at age 65 will lose all their OAS benefit once their retirement income reaches the maximum threshold of $128,137 (in 2020). But someone who delays OAS to age 70 will lose all their OAS benefit once their retirement income reaches a maximum threshold of $145,806 (in 2020).

2. Maximize TFSA Each Year

Tax-free-savings-accounts (TFSAs) are a great way to grow your money tax free. If you have not reached your contribution limit yet, adding extra investments to the TFSA can help avoid OAS clawbacks. These investments will grow completely tax-free and will be tax-free when withdrawn. This means they will not trigger OAS clawbacks now or in the future. Retirees can also shift investments into their TFSA each year as new contribution room becomes available. This means that a retiree may experience a large OAS clawback now, but this can decrease in the future as they shift money into their TFSA.

3. Income Splitting

For couples, income splitting can be very useful when one partner makes much more/less than the other. There are certain types of income that can be split in retirement. Because OAS is an individual benefit, this splitting can help lower income for one person in the couple, allowing them to reduce OAS clawbacks. If a couple made $154,000 collectively, ideally income splitting would allow both people to have a net income of $77,000, just below the OAS clawback threshold, which would allow both of them to qualify for full OAS benefit.

4. Avoid More RRSP Contributions (In Some Cases)

At a certain point RRSPs can become counter productive. To make sure RRSP contributions are still attractive it’s important to look at Marginal Effective Tax Rates before and after retirement. The METR is the combination of income tax rates and government benefit clawback rates. For some retirees, they may be contributing at a lower METR while working than they’ll face when withdrawing in retirement. If a retiree is going to face a 15% OAS clawback then depending on their income level now it may make sense to avoid RRSP contributions.

5. Drawdown RRSPs Before Starting OAS

Similarly, partially melting down the RRSP before starting OAS can also help avoid OAS clawbacks. RRSP and RRIF withdrawals count toward taxable income and if these withdrawals cross over the income threshold they will trigger OAS clawbacks after age 65 (or whenever OAS begins). A retiree with a pension of $60,000 per year will experience OAS clawbacks on any RRSP/RRIF withdrawal that is above $19,054 (the combination being the OAS clawback threshold of $79,054 for 2020) Ideally a retiree can melt down an RRSP a bit faster before starting OAS and then place those extra withdrawals inside a TFSA to continue growing tax free. But another option may be for a retiree to melt down an RRSP and place those funds in a non-registered investment account.

6. Type Of Investment Income

Some higher income retirees have maxed out their RRSP and TFSA, they’ve been forced to invest in a non-registered account. These non-registered investment can generate different types of investment income and each type of investment income will experience different OAS clawbacks based on their tax treatment.

Interest income from a savings account, GIC or bond will trigger a 15% OAS clawback because it’s considered regular income.

Foreign dividend income is treated similarly, as regular income.

Capital gains income from the sale of stocks or other capital property will only trigger a 7.5% OAS clawback. This is because only 50% of capital gains are included in taxable income. This inclusion rate means that $100 of capital gains will only increase taxable income by $50 and therefore only trigger $7.50 of OAS clawbacks.

Eligible dividend income from Canadian companies will trigger a 20.7% OAS clawback. This is because eligible dividends are “grossed up” by 38% before being included in taxable income. This gross up rate means that $100 of capital gains will increase taxable income by $138 and therefore trigger $20.70 of OAS clawbacks. (Or course, eligible dividends get preferential income tax treatment thanks to the dividend tax credit so the income tax rate is lower than foreign dividends or interest income, this is why it’s important to not only look at the OAS clawback but the full METR).

7. Plan Large Capital Sales (Cottage, Vacation Home, Stocks etc)

The last strategy to help avoid OAS clawbacks is to plan large capital sales. The sale of capital assets like a cottage, vacation home, stocks etc will potentially trigger OAS clawbacks in the year of sale.

When capital gains are triggered by the sale this will increase taxable income by 50% of the capital gain (this 50% is called the inclusion rate). This increase in taxable income will also trigger OAS clawbacks if OAS benefits have started and if income crosses the OAS clawback threshold.

This is especially important for pre-retirees with rental properties. If the property doesn’t create enough cash flow relative to the equity in the property, these properties may need to be sold to access the capital to help create retirement income. If sold after OAS has started this may trigger extra OAS clawbacks which could have potentially been avoided.

The Impact of OAS Clawbacks

So how impactful can OAS clawbacks be in retirement? They can be very impactful for some higher income retirees.

When OAS is taken at age 65 the typical retiree will receive an OAS benefit of $7,362 per year (in 2020) and over the course of a 30-year retirement would receive payments of $220,860 (in today’s dollars). That is a significant amount of retirement income!

Experiencing full OAS clawbacks would mean that a retiree needs to make up this income on their own through extra investment assets. If we use the 4% rule for withdrawals, then a retiree would need $184,050 in additional investment assets at the beginning of retirement to make up for the loss of OAS benefits.

On top of this, a retiree also loses the indexing benefit of OAS when they experience clawbacks. One of the great benefits of OAS (and CPP) for retirees is that it is an inflation adjusted government pension. This inflation adjustment provides a great deal of protection against high inflation. If we were to experience a period of high inflation (like the 1970’s) then a retiree who receives the full OAS benefit will have an extra layer of protection versus those who experience a clawback.

This inflation adjustment is especially beneficial for retirees who may not have an inflation adjusted defined benefit pension. For retirees who need to create most of their retirement income through investment withdrawals, an inflation adjusted government pension is a huge benefit in retirement.

The security that the OAS benefit provides is very important for retirees so we want to avoid clawbacks when possible.

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Avoid OAS Clawbacks In Retirement

Avoiding OAS clawbacks is an important part of retirement planning. We’d like to avoid these clawbacks if at all possible. Through various strategies we can reduce or eliminate these clawbacks in retirement. This can be very beneficial to a retiree.

Which strategy makes sense will depend on the retirees sources of income and financial assets.

The OAS clawback rate is quite high at 15%. When combined with income tax rates, the combination can be in the 40%+ range and even as high as 50%+

Experiencing these clawbacks means that a retiree loses the benefit of an inflation adjusted pension, they also require additional savings & investments to support the same level of spending.

Avoiding OAS clawbacks can be very beneficial for a retiree and sometimes all that is needed is a bit of planning.