RRSP Meltdown Strategy: A Canadian tax lawyer's tax guidance
Tax lawyer and accountant David Rotfleisch looks at a unique retirement financial strategy to create tax neutrality on RRSP withdrawals
What is an RRSP Meltdown?
The Registered Retirement Savings Plans (RRSP) offer Canadians a great opportunity to defer tax in their retirement savings. When you contribute to your RRSP account, you can deduct the amount of the contribution from your gross income before tax which reduces your tax liability for the year and defer tax on earnings until withdrawal. However, when you withdraw money out of your RRSP, you increase your taxable income for the year and the withdrawal will be taxed at your marginal tax rate (except for first-time home buyers plan or lifelong learning plan). In addition, if you don't have a spouse or common-law partner, the full fair market value of the assets in your RRSP must be included in your income upon death, and they are typically taxed at the highest marginal tax rate.
The [meltdown] strategy is to create tax neutrality on your RRSP withdrawal by obtaining a personal investment loan that generates an interest deduction equal in amount to ongoing RRSP withdrawals. Since the interest payment from the investment loan is tax deductible, it will cancel out the taxable income created by the RRSP withdrawal. You must use the loan to purchase dividend-paying stocks or guaranteed income funds in order to create tax deductibility for the interest paid. Let's take the following example to illustrate this strategy:
Suppose the bank offers a line of credit that charges 5% per year and you want to withdraw $5,000 annually from your RRSP. To offset the $5,000 withdrawal, you will need to borrow $100,000 to invest in income-producing portfolio, which generates $5,000 of interest payment per year. However, there are risks associated with this strategy and it may not be suitable for everybody.
What are the risks?
- Investment return should cover the interest payment
For this strategy to work, the investment should have a return rate that equals to at least the interest rate of the loan. In the example mentioned before, the investment portfolio should yield at least a 5% return per year to over the interest associated with the loan. Otherwise, the person will be left with negative cash flow.
- Determine your risk tolerance
Another important thing to keep in mind before going into this strategy is to measure how comfortable you are with investment risks. There is a real risk in borrowing money to invest when the investment portfolio drops in value and the investor sells the whole portfolio but is unable to pay back the original loan. Even if the investment returns are positive, they may still not be enough to cover the interest payment so you should always have alternative sources to cover that cost. It is not recommended to go into this strategy unless you are an experienced investor and have professional help.
- What is your time horizon?
The RRSP meltdown strategy generally requires a time commitment of at least 10 years. A long investment time horizon increases the probability for your investments to appreciate in value in an amount that exceeds your loan plus interest costs and creates a potential of lower volatility on investment returns. However, the longer you live after taking out the early withdrawal, the less efficient this strategy may become because you are giving up the tax deferral that comes from leaving the assets in your registered plan. If you suspect you have a long-term deferral time of 20 years or more your advisor should do some calculations to see if it is more advantageous for you to leave the funds in your registered plan.
- Understand how your retirement will be affected
This strategy often involves converting your registered assets that you intended to use after retirement into non-registered assets. One thing you should keep in mind is that once you make a withdrawal from your registered accounts, you cannot recontribute the money back as that room is forever lost. Also note that taking money out of your registered plan early can trigger the claw-back of Old Age Security benefits as your income rises.
Know the risk before you go into the RRSP meltdown strategy
Although it is possible to withdraw money from your RRSP early tax-free, the question is whether it is worth the risk. Having said that, a well-designed plan is critical to avoid tax liability when you retire and have to withdraw your RRSP funds.
David J Rotfleisch, CPA, CA, JD, is the founding tax lawyer of Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law firm. With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. Visit www.Taxpage.com and email David at firstname.lastname@example.org. Image courtesy: David J. Rotfleisch.