RRIF meltdown strategy
Financially successful people have a few common traits. They work hard, they spend less than they earn, they build wealth by investing and they try to minimize the taxes they pay.
One of the tools that has helped Canadians build retirement assets is the RRSP. The advantages of the RRSP are pretty straightforward. You get to use your contribution as a tax deduction and all of the growth in the RRSP grows tax-free. For me, this is precisely the reason I have maximized my RRSP every year since I have started working.
However, every investment and financial tool has positives and negatives and you do not hear too much about some of the not so positive points of the RRSP:
- You become partners with the CCRA. The minute you invest in the RRSP, you must abide by the rule of the government. They have a say in terms of how you invest the funds (like foreign content restrictions and qualified investments) and when you have to start income (age 69) and how much you must withdraw in income (minimum income). While there is still a lot of flexibility and choice, there are some restrictions that everyone should be aware of.
- Investing outside the RRSP has become more tax efficient. Astute investors may be able to invest in such a way where they can minimize the amount of tax they pay on investment income outside the RRSP. With lower capital gains, inclusion rates, index investing, ETFs, corporate structures and mutual funds designed to be tax efficient, investors can create tax efficient portfolios, which might mirror the tax-free growth inside the RRSP.
- Every dollar that is withdrawn from the RRSP is taxed at your marginal tax rate. So while you get the benefits of the deduction and tax growth, you will eventually pay tax on the capital and growth. As a result, it is important to try to understand what marginal tax rate you might be in when you finally start to take money out of the RRSP. If you contribute and get a 35% tax deduction but eventually take that money out at a 45% tax rate, that may not be the best situation to be in. Rather, you want to get the 45% deduction when you contribute and pay the 35% when you withdraw the funds.
Can you get the RRSP money out tax-free?
This would be one of the most common questions I get in my travels as a financial advisor. The good news is there is a strategy known as the RRSP (RRIF) meltdown which can help Canadian’s get their RRSP money out without paying tax.
Let me explain with an example:
Let’s assume Barb, age 50, has $100,000 in RRSPs. Barb has invested the money in a balanced portfolio and will earn an average of 7% over time. Barb wanted to know how she could withdraw the $7000 of growth per year from the RRSP without paying tax.
The only way to avoid paying the tax is to somehow create a $7000 tax deduction to offset the extra income. The end result is there would be no added income and therefore, no added tax.
One of the ways to do this is to incorporate leveraging. Continuing on this example. Barb could go out and borrow $100,000. At a 7% interest rate, this would mean that Barb would pay $7000 of interest per year. In order to make that interest tax deductible; she would have to use the $100,000 for investment purposes with the intent to earn income. Let’s assume Barb invests the $100,000 into tax efficient mutual funds.
In this example, Barb has now moved the taxable growth of the RRSP into a more tax efficient non-RRSP environment. After 20 years, Barb will have $100,000 in the RRSP/RRIF and $287,000 outside the RRSP (after paying off the $100,000 loan) for a total of $387,000 (pre-tax). If she left the RRIF to compound at 7%, she would have $361,625 (pre-tax) in the RRSP.
The important difference here is that with more assets outside the RRSP, she has more flexibility and a smaller tax liability.
Proceed with caution
It is important to disclose that this is one example and will not apply to everyone. There are many assumptions that will be different for different situations. Make sure you speak to an investment professional for advice when it comes to leveraging. As great as this example may be, leveraging is not for everyone. There are risks to leveraging that you must be aware of before you consider the RRSP meltdown strategy. Leveraging is complicated and you must take the time to understand all of the risks and implications.