The risks outweigh the rewards of an RRSP meltdown strategy


An RRSP meltdown strategy sounds like a great way to collapse an RRSP without paying taxes—but in reality it’s a lot riskier than it sounds.

A RRSP meltdown is a strategy some financial advisors suggest as a way to withdraw money from an RRSP while paying little or no income tax.

In the simplest form, you set up an investment loan and make the interest payments from RRSP withdrawals (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 use the investment loan to buy dividend-paying stocks, which provide you with income during retirement. Dividend-paying stocks also have the advantage of being very tax efficient.

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However, RRSP meltdown arrangements often 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.

Investors who participate in this RRSP meltdown procedure are 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 RRSP meltdown investor a steady income. But the guarantee is very likely 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.

I have looked at a number of these so-called RRSP meltdown deals over the years, and have yet to come across one that inspires my confidence.

No direct way to avoid taxes

There’s no direct way to take money out of an RRSP without paying tax at the rate you would have to pay on ordinary income.

However, there are legal ways to lower your taxes on RRSP withdrawals.

You can make a contribution to a spousal RRSP. This way, when the money is withdrawn years later, it is taxed in the hands of your spouse, who may be in a lower tax bracket than you are. It’s also a good idea to plan things so that you use spousal RRSPs to split your retirement income between you and your spouse. This can lower the total tax burden on your retirement income as a couple.

Another way to lower the overall tax burden on your RRSP withdrawals is to make withdrawals in low-income years—even if you don’t need the money in those years. You’ll lose the tax-shelter on future earnings, of course. But you may reduce your taxes in the long run, particularly if you invest your RRSP withdrawals in stocks that you hold on to for many years.

It’s possible to use your own RRSP funds to make a mortgage loan on a home you are buying and gradually pay it back to your RRSP. But in light of the fees involved, it may be cheaper to get a mortgage from a conventional lender.

What returns can I expect from using an RRSP?

Before even considering anything like an RRSP meltdown strategy—or any kind of withdrawal for that matter—you first need to determine what kind of returns you are looking at from your RRSP. Many investors are confident they are taking concrete steps toward a secure retirement. But are those steps based on realistic calculations?

Let’s say you’re 50 and you want to retire at 65. You have $200,000 in your RRSP, and you expect to add $15,000 in each of the next 15 years. To determine if this is enough to retire on, you need to make assumptions about investment returns and income needs.

Long-term studies show that the stock market as a whole generally produces total pre-tax annual returns of 8% to 10%, or around 6% after inflation. For retirement planning, we’ll assume a 6% yearly return, and disregard inflation. Your $200,000 grows to $479,312*, and your yearly $15,000 RRSP contributions add up to $370,088, for total retirement savings of $849,400.

*****Be sure to check your math. There are many compound-return calculators available online. For example, you can find a comprehensive compound-return calculator at the Bank of Canada’s web site.

If you continue to earn 6% a year, and you withdraw $50,964 a year (6% of the $849,400 in your RRSP), you can avoid dipping into capital until your mid-70s, when RRIF rules call for steadily rising withdrawals.

However, if you start taking money out faster, or earn lower returns, you’ll run out of money. If you withdraw $90,000 a year while earning 6%, the money you’ve accumulated will last just over 13 years. If you earn 5% but withdraw $90,000 a year, your money will be gone in just over 12 years.

Have you considered the RRSP meltdown strategy? Do you know anyone that has attempted to navigate an RRSP meltdown? Share your experience with us in the comments.

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