Despite their promise to ease your tax burden on withdrawals, RRSP meltdown strategies are usually more lucrative for brokers than for investors. “RRSP meltdown” is a strategy that would let investors make withdrawals from their RRSPs without paying income tax. But some meltdown strategies are extremely risk and could jeopardize your retirement.
How the RRSP meltdown works
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.
According to the strategy, 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.
Judging an RRSP meltdown strategy 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 you’d generate when you invests the money are an obvious benefit to your broker. Meanwhile, you significantly increase your 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 meltdown strategies 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.
No benefit to connecting investment loans 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.
Courtesy Fundata Canada Inc.© 2015. Patrick McKeoughis a professional investment analyst and portfolio manager. He is the host of TSINetwork.com, where this article first appeared. Investments mentioned are not guaranteed and carry risk of loss.
