The RRSP/RRIF meltdown strategy is a tax-efficient method to convert some of your registered assets into non-registered assets using an investment loan. This guide will explain the strategy, including a detailed look at the loan portion, and its potential issues to help you decide if it fits into your financial plan.
Understanding the Strategy
When you withdraw money from your RRSP or RRIF, it is fully taxable at your marginal rate in the year of withdrawal. If you pass away without a qualifying beneficiary, the full market value of your RRSP or RRIF will be included in your income and taxed at the highest rate.
The meltdown strategy suggests making early withdrawals from your RRSP or RRIF when your tax rate might be lower than it would be later. You then use these funds to pay the interest on an investment loan. The withdrawals should match the interest payments on the loan.
Benefits of the Strategy
From a tax perspective, the strategy offsets the income from your RRSP or RRIF withdrawal with an interest expense deduction from your investment loan. This can create a tax-efficient portfolio that benefits from the lower tax rates on capital gains and dividends outside your registered accounts.
Detailed Look at the Loan Portion
- Purpose of the Investment Loan: The investment loan is central to the meltdown strategy. By borrowing to invest, you can potentially increase your investment capital and benefit from tax deductions on the interest paid.
- Interest Payments: The interest on the investment loan should be paid using withdrawals from your RRSP or RRIF. This aligns the strategy with tax regulations, allowing the interest to be deductible, which can offset the taxable income from the withdrawals.
- Tax Deductibility: For the interest on the investment loan to be tax-deductible, the borrowed money must be used to earn income, such as dividends or interest from investments. This requirement ensures that the strategy remains tax-efficient.
- Example Using a RRIF:
- Imagine you borrow $50,000 at a 6% interest rate and invest the money in a non-registered portfolio.
- You would pay $3,000 in interest each year.
- You withdraw $3,000 from your RRIF to cover this interest, assuming this is your minimum required payment with no withholding tax.
- The interest on the loan should be deductible, offsetting the $3,000 RRIF income inclusion.
Considerations for Withholding Tax
Withholding taxes apply to RRIF withdrawals beyond the minimum or any RRSP withdrawals. If you need $3,000 to pay interest, you might have to withdraw more to cover these taxes. For instance, withdrawing $3,333.33 from your RRSP to net $3,000 after a 10% withholding tax.
Investment Mix
Creating a tax-efficient portfolio involves holding investments like capital gains and Canadian dividends outside registered accounts while keeping interest income within registered accounts to defer tax. Consider the investment’s risk, diversification, potential for growth, and liquidity.
Factors to Consider
- Marginal Tax Rate: If your current tax rate is not much lower than the expected rate at death, the strategy may not be beneficial.
- Time Horizon: A longer investment horizon increases the chance of your investments growing to cover the loan and interest costs. If you expect a long-term deferral, leaving funds in the registered plan might be better.
- Surplus Cash Flow: Ensure you have enough non-registered funds to make principal repayments and cover potential increases in borrowing costs or declines in investment value.
- Investment Risk Tolerance: Borrowing to invest adds risk. Diversification can help reduce investment volatility.
- Impact on Retirement: This strategy replaces registered assets intended for retirement with non-registered assets, which could affect your retirement expenses. Also, early withdrawals from registered plans can impact income-tested benefits like old age security.
Keeping Interest Tax-Deductible
To keep interest deductible, use the borrowed money to earn income from a business or property. If the investment provides a return on capital (ROC), reinvest the ROC to maintain deductibility.
If you sell investments bought with the loan, reinvest proceeds to keep the interest deductible. Using sale proceeds for personal purposes stops the interest from being deductible.
Conclusion
The RRSP/RRIF meltdown strategy can be tax-efficient but involves risks. It’s typically used by those nearing or in retirement. Work with a qualified financial planner to see if this strategy suits your financial situation. If you are curious about his strategy, you can book a meeting with me and also consider picking up my book “The Art of Retirement“.
