RRSP meltdown strategies promise to ease your tax burden on withdrawals, but these complicated manoeuvres are usually more lucrative for brokers than for investors
Investors sometimes ask us what we think of the so-called RRSP meltdown. This is a strategy that would let them make withdrawals from their RRSPs without paying income tax.
How the RRSP meltdown works
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When you take money out of your RRSP, you have to pay tax on your withdrawal at the same rate as ordinary income in the year you make the withdrawal. However, under an RRSP meltdown strategy, you would offset the additional tax by taking out an investment loan and making the interest payments from funds you withdraw from your RRSP (the withdrawals must be equal to the interest payment).
Since the interest on the loan is tax deductible, the tax on the RRSP withdrawal is cancelled out. This, in theory, results in zero tax owing on your withdrawal.
You can then use the investment loan to buy dividend-paying stocks, which you would use to provide income during retirement. Dividend-paying stocks also have the advantage of being very tax efficient.
RRSP meltdown by the numbers
The idea of withdrawing funds from an RRSP tax free has obvious appeal. However, we’ve looked at a number of different RRSP meltdown strategies over the years and, for the most part, we have found that they serve the interests of the brokerage industry more than those of investors. Here’s why:
Say you make a $5,000 withdrawal from your RRSP and want to offset your tax payable using the interest from an investment loan. Supposing a 5% annual interest rate on the investment loan, you would have to borrow $100,000 to invest in dividend-paying stocks to generate a large enough interest deduction to offset the withdrawal.
The fees and commissions that the investor generates when he or she invests the money are an obvious benefit to the investor’s broker. The investor, meanwhile, significantly increases his or her leverage. Moreover, many investors attempt the RRSP meltdown when they’re at or near retirement. In other words, at the worst time to take on additional debt.
Some RRSP meltdowns involve extreme risk
Some financial advisors take this to a ridiculous extreme by offering arrangements that involve making RRSP withdrawals and placing the money in business or real-estate deals that generate large tax deductions. These then offset the taxable income from the withdrawals.
The investor who has participated in this type of meltdown is then left holding an illiquid, and often quite risky, investment. To generate the tax deductions, you may also have to take out or guarantee a large debt.
Sometimes the deal “guarantees” the investor a steady income. But the guarantee is sure to be full of holes. The only things that are reliably guaranteed in these deals are the huge fees and commissions they generate for the salespeople and financial institutions involved. This type of meltdown strategy is never a good idea—no matter where you are in your investing career.
Borrowing to invest can be a good strategy—but there’s no benefit to connecting it to RRSP withdrawals
Of course, borrowing to invest can go wrong if you buy at the top of the market and sell at a low. However, taking out an investment loan can be a good investment strategy for certain investors.
For example, you may consider borrowing to invest if you are in the top income tax bracket and expect to stay there for a number of years, you have 10 or more years until retirement, and you have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan.
Either way, we see no benefit in complicating matters by tying your investment loans to RRSP withdrawals.
Bonus Tip: Index-linked GICs maximize the promises but minimize the payouts
Index-linked GICs (guaranteed investment certificates) provide the buyer with a return that is “linked” to the direction of the stock market in a given period. A quick look at the rules on these deals may give you the impression that the investor can profit substantially with little risk. However, the link depends on a formula or set of rules that is buried in the fine print.
These investments are marketed as offering all of the advantages of stock-market investing with none of the risk. But banks and insurance companies aren’t in the business of giving customers something for nothing. The capital gain that holders get depends on an ingenious formula, which is cleverly designed to sound generous while minimizing the potential payout.
This article was originally published in 2010 and ii is regularly updated.
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My approach in Retirement has been 1) Move RRSP to a RRIF –no cost use same company 2) remove minimum withdrawal each year “in kind” and 3) transfer directly into a TFSA and let it keep growing 4) if extra $$ needed take from RRIF . It has been working well as my TFSA has kept growing as well as what remains in my RRIF. I also have a pension and spend my CCP & OAS as needed first.
Thanks for sharing, Bill.
RRSP meltdown ideas: as you wrote about, the risks of taking on debt to generate a deduction are what worries me about these RRSP meltdown procedures. I do want to lessen my tax burden on RRSP withdrawls, so if you can help with that it would be worth money to me. Peter Jones
Thanks, Peter. Here’s a link to more details on RRSPs and RRSP strategies.