I’ve written before that there are some situations in which you would want to avoid saving too much to your RRSPs. In one way or another, the reason comes down to taxes.
The most common reasons cited for monitoring the value of your RRSPs:
1. Withdrawals are subject to your full marginal tax rate.
2. Registered withdrawals add to your earned income.
2. If your income is too high it may trigger clawback of your Old Age Security benefit.
3. You are required to make minimum annual withdrawals from age 72 onwards even if you don’t need the money.
4. Non-Registered assets can be taxed much more preferentially (while living and at death).
Because of these main reasons, strategies have been developed to shift assets from registered accounts to non-registered accounts – these are known as meltdown strategies.
Before I continue however, don’t forget that many people would be envious of your problem! :)
There are actually two basic ways to melt down an RRSP. One involves simply withdrawing money from your RRSP while you are in a lower tax bracket and the other involves offsetting the RRSP withdrawal with tax deductible investment loan interest. Most people will marry the moniker of the “RRSP Meltdown” (or RRIF Meltdown) with the strategy that involves the investment loan – but the straight withdrawal method is also considered a meltdown.
1. STRAIGHT WITHDRAWAL MELTDOWN
This strategy mostly applies to higher net worth individuals who do not need to access the funds in their RRSP accounts for their retirement living expenses. In this strategy, you are simply withdrawing funds from your RRSP early and re-allocating them to a non-registered investment account where the funds will continue to grow (albeit taxed on a yearly basis for interest, dividends and distributed capital gains). The hope is that you will save tax on your terminal tax return since you had slowly converted assets from being fully taxed at your marginal rate to assets that are only taxed on the growth (and hopefully most of that growth was in the form of capital gains thereby further reducing the tax bill).
You can see that this strategy really fits only a few situations in real life – namely because it assumes that the money in the RRSP isn’t needed for your living expenses, but is rather earmarked as an inheritance (for a non-qualified beneficiary).
Up until a few years ago, for this strategy to really make sense would depend on you NOT living too long as the extra growth afforded by the tax sheltered RRSP eventually offset the extra taxes owed by the RRSP. Since your death is mostly an unknown variable, you wouldn’t know if the strategy would have played out in your favour until you were on your deathbed. Nowadays, we have more tax-efficient investments avaiable for non-registered environments so the appeal is starting to come back.
2. THE LEVERAGED MELTDOWN
The RRSP Meltdown strategy that everyone is normally referring to is this one. This is where you take out an investment loan in a non-registered investment account and the interest payment on the loan is used to offset the RRSP withdrawal.
I usually see examples that propose the interest on the loan be equal to the RRSP withdrawal which allows for a zero-sum tax event. For example, assuming you are in a hypothetical 40% tax bracket your $10,000 RRSP withdrawal would be deemed to be earned income in the amount of $10,000 – which would be subject to $4,000 in tax. BUT, if you had paid $10,000 in interest on your investment loan that year then you would have an offsetting income deduction of $10,000 which would cancel out the $10,000 RRSP withdrawal’s effect on your tax return.
But consider that to have a $10,000 interest payment you would need an interest-only loan of about $143,000 (assuming 7% interest charged on the loan). To have a $10,000 interest payment on a term loan would necessitate an even larger loan amount since part of your payment will be a repayment of principal.
So while most people will promote the strategy with perfectly offsetting interest and withdrawal amounts – it is not necessary – and usually not practical.
The people using a leveraged meltdown strategy are trying to reduce the amount of tax they pay while they are living and as such, they want to slowly shift assets from being in a registered environment to a non-registered environment. Also note that you don’t have to completely meltdown your RRSP to $0 either. It really will come down to a number of factors (such as rate of return, longevity, asset allocation, projected annual incomes, etc.).
You need to consult with a professional to see if either of these strategies even make sense for your own situation first, but then also to see to what degree you need to implement them. Also be cautious that the advice is genuine as if your advisor is paid based on the assets he/she manages this creates a conflict of interest since this will increase the amount of investment assets you hold with him/her.
In Part 2 and Part 3 I will explore a few examples of the Leveraged Meltdown Strategies. You will see that it only works if “all the stars are aligned”. From the analyses that I had made, there are very few situations that justify taking on the amount of risk involved with interest-only leveraged meltdowns.
I suppose a third alternative is one I can propose now: RETIRE EARLIER DUMB-ASS! :)