Canadians can neutralize the tax bite on RRSP withdrawals with long-term strategy – though it's not for the risk-averse
RRSPs offer Canadians a great way to defer tax on their retirement savings, but the key word is “deferred.” Upon withdrawal, the RRSP holder will see their taxable income increase for the year – except in the case of the first-time homebuyers plan or lifelong learning plan – with the withdrawal being taxed at the person’s marginal tax rate. Death doesn’t reduce the certainty of taxes, either, as the full fair-market value of assets left in an RRSP after death will be subject to taxation at the highest marginal rate for those who die without a spouse or common-law partner.
But as Canadian tax lawyer David Rotfleisch explained in a recent column, there’s a way to neutralize the pain of that deferred tax. The strategy, called RRSP meltdown, involves obtaining a personal investment loan that generates an interest deduction that’s 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,” he said, emphasizing that tax deductibility for the interest paid can only be ascertained if the loan is used to purchase dividend-paying stocks or guaranteed income funds.
Of course, the strategy is not without risk. For one thing, Rotfleisch said, the investment made from the proceeds of the personal investment loan should generate returns that are at least equal to the interest rate of the loan. Those considering this strategy, he added, should reflect deeply on how comfortable they are with the risks of borrowing for investment, including the possibility that the portfolio collapses in value or the investment returns are not enough to cover the interest payment.
The strategy generally requires a long-term commitment of at least 10 years, he went on, stressing that the long time horizon increases the likelihood that the investments appreciate enough to exceed the value of the loan plus interest costs. But on the flip side, the longer an investor lives after taking out the first withdrawal, the greater the opportunity cost associated with giving up the tax deferral that would have come from leaving the assets in the 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,” Rotfleisch said.
Beyond that, the strategy also has implications for Canadians’ retirement. Namely, withdrawing a certain amount from a registered account means forever giving up that amount of contribution room (which means the money can’t be recontributed) and that early withdrawals from an RRSP can trigger a clawback of OAS benefits as income rises.
“Although it is possible to withdraw money from your RRSP early tax-free, the question is whether it is worth the risk,” Rotfleisch said.