HERE IS AN EXCERPT FROM THE ADVISOR LEVEL

 

Strategy #29: The RRSP Meltdown: Two Types

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.
3. If your income is too high it may trigger clawback of your Old Age Security benefit.
4. You are required to make minimum annual withdrawals from age 72 onwards even if you don't need the money.
5. 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 – See Strategy 38 – Naming a Proper Beneficiary for Your RRSP).

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. These days, we have more tax-efficient investments available 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 (the interest on an investment loan MAY be tax-deductible if the investments are held in a non-registered account).

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.

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 should consider consulting 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.

Very often, leveraged meltdowns only work 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.

Also, it is worth pointing out that a third alternative exists: RETIRE EARLIER! :)

From the calculations I made below (which don't even factor in variance of actual returns in the real world!) the risks in this strategy are too great for all but the most speculative investors.

COMPLETE OFFSET

Let's look at what would be involved in completely offsetting the RRSP withdrawals with interest on an investment loan. First we need to make a few assumptions:

1. Our investor is 55, will retire at 65 and will live to 90.
2. He has $350,000 in his RRSP.
3. All his investments grow at 8%.
4. His loans are charged 7% in interest.
5. His marginal tax bracket is 45%.
6. He has other sources of income in retirement such that the income from his RRSP will all be taxed at his marginal rate.

If he wanted to completely meltdown his RRSP by the time he retires, that gives him 10 years to melt down $350,000 that is growing at 8%/year. That means he would have to withdraw $48,300 (rounded) per year in order to have $0 in his RRSP by age 65.

If we tried to offset $48,300 in taxable income with deductible interest from an investment loan we need to calculate how much the loan principal would be to support that. Assuming an interest only loan and working backwards we find that $690,000 at 7% per year equals $48,300. That's one heck of a loan!

Fast forward to age 65. Now our investor has $0 in his RRSP, but his non-registered investment has grown from $690,000 to $1,490,000 (rounded, growth at 8%). Since the RRSP is now depleted, we can no longer afford the interest on the loan so we will have to collapse the leverage. If we subtract the loan principal of $690,000 this leaves us with $800,000. But don't forget that in order to pay off the loan, we would have to sell some of the investment which would incur tax. So if we sold $690,000 (and to be conservative let's assume the whole amount is a capital gain) then there would be an additional tax bill of $155,250. Once this is subtracted from the $800,000 we are now left with $644,750.

Let's go back and see what his RRSP would have grown to by age 65 if he had not made any withdrawals: At 8%/year we have $755,623. So looking at the absolute values, it looks like the non-melted-down RRSP is actually better - but...

To be thorough, we should look at how the ongoing withdrawals are taxed (to see how much he would have to spend) if we depleted both accounts to $0 by age 90.

For the non-melted-down RRSP, $755,623 growing at 8%/year and being depleted to $0 by age 90 would allow for annual withdrawals of $65,500 (rounded). If they are taxed at 45%, then his net income per year would be $36,025 (rounded).

For the meltdown, the non-registered account of $644,750 would allow for annual withdrawals of $55,925. Again being on the conservative side, let us assume that ALL withdrawals are realized capital gains and therefore 50% of the withdrawals are subject to 45% tax. In this case, the net income per year would be $43,341 (rounded). That is a sizeable advantage of $7,000+ per year in his pocket versus the non-melted-down RRSP!

(For those who are interested in seeing the after tax effects if the RRSP or melted down RRSP was the ONLY source of retirement income, or in other words if his marginal tax bracket didn't apply to the full amounts, then I calculated the net income [including OAS Clawback] as follows for each: non-melted-down RRSP=$56,721, melted-down RRSP=$52,502; these figures may seem artificially high compared to the results above, but this is because I ADDED CPP AND OAS to these numbers since it makes a difference if we are calculating THROUGH multiple tax brackets. For the above numbers, if those income amounts were indeed taxed entirely at 45% then the tax on their CPP would be equivalent and their OAS completely clawed-back.)

Okay, so we've seen that a leveraged meltdown works in theory for those who will be very much in the highest tax bracket in retirement. But look at the assumptions that we have made: Our investor had to take out an interest-only loan for $690,000! We also assumed that he would generate a static 8% rate of return on all his investments.

In practice, this person might have difficulty getting approved for an interest-only loan for $690,000. Further, the risk in this strategy is enormous. The first few years will make or break you in a big way. If there were a bear market near the beginning of this strategy, consider that not only will your leveraged investment's balance look scary, but the odds of being able to keep up with the RRSP withdrawals while your RRSP is experiencing negative growth greatly diminish. If you ran out of funds in your RRSP, you might also be under water in your leveraged investment. That's a serious double whammy!

Let's see what happens when the market only provides your portfolio with a 5% return:

1. Your RRSP would be depleted at around 8.5 years.
2. At that time your leverage would be worth $1,045,000.
3. You would no longer have funds to withdraw from your RRSP to pay the interest on the leverage so you would have to collapse the loan.
4. After paying off the loan of $690,000 that leaves you with $355,000.
5. After paying the tax for that, you are left with about $200,000!

Alternatively, if you just let your $350,000 RRSP grow at 5%, at 8.5 years in you would have about $530,000.

Hmmm... $530,000 with no leveraged meltdown versus $200,000 WITH a leveraged meltdown if the markets only return 5%... Can you see how much risk is involved with a completely offsetting leveraged meltdown??? The lowest 10 year rolling average rate of return since 1950 on the TSX was 3.3% so even if you had what it takes to buy and hold, yes you could "make a positive return" but the chances (to me) of having a rate of return LOWER than the interest charged on your loan are PRETTY GOOD. Too good in fact, to make a strategy like this endorsable to all but the most speculative of investors.

WHAT ABOUT A TERM LOAN?

This is complicated. If you were planning on withdrawing money from the non-registered account for living expenses - this strategy will flat out not work! Allow me to explain:

Using a 10 year term loan for HALF the value of the RRSP (as opposed to an interest only loan and completely melting down the RRSP) requires us to point out a few items: With a term loan the amount of interest will be less than the RRSP withdrawal annually so there will be some tax owing. This is because the term loan payment is part interest and part principal. Since we did not use any "surplus cash flow" in the above scenario, it wouldn't be fair to just assume that our investor can make up the shortfall in this scenario caused by the tax on the RRSP withdrawals that are not offset by deductible interest. Therefore, he will have to pay for the extra tax by redeeming even more of his RRSP! (This is the main reason the strategy won't work).

Also, with a term loan, the interest makes up about half the loan payments in the first year, but in the last year only makes up about 7% of the loan payment - so his tax bill goes up every year, meaning he has to redeem more and more money out of his RRSP each year until the loan is paid off.

I created a spreadsheet to figure out the impact of the increasing redemptions to the RRSP on top of the static annual loan repayments of $25,057, and the rate of growth of 8% on the funds annually. I'll spare you the math: the RRSP value after 10 years is almost exactly $200,000 even.

So now let's check on the value of the $175,000 invested into the non-registered account (this is half of the RRSP's value at the start of the 10 years). This one is pretty easy as we just have to take the lump sum and grow it at 8%/year which gives us: $377,800 (rounded). Unlike before, we don't have a loan balance to pay off as we have been paying it off all along. So in this case we have $200,000 in the RRSP and $377,800 in the non-registered account at age 65.

To figure out the combined net income after tax if our investor were to withdraw the funds annually such that both accounts would deplete to zero by age 90 would allow for... $34,937/year after tax? That is below the after tax annual amounts for a full meltdown AND if we didn't meltdown at all ($43,341/year and $36,025/year respectively). What gives?

Well, if you'll remember we took out a term loan of $175,000 over 10 years. That means that $175,000 of the payments over the 10 years was just PRINCIPAL - which cannot be deducted. Over the years that also added up to around $140,000 in extra tax owing. These drains are just too much to overcome for this strategy to be effective... (at least for our test case)

FINAL THOUGHTS

Does the RRSP Leveraged Meltdown work? In theory, yes it does, but only if you expect to be comfortably in the highest tax bracket throughout retirement. If your RRSP is the only source of retirement income (asides from CPP and OAS) then a meltdown would probably never make sense.

If your clients do fit the criteria of being comfortably in the top tax bracket, keep in mind that in the real world the risks involved are so great that I have to re-iterate that it is probably only suitable for the most speculative of investors (and even then it seems questionable). Tread carefully.

 

 

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