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RRSP Meltdown Strategy

I've been thinking about RRSP's lately, and I'm going to talk about a strategy that I came by that I'd like to share with you.  This tax strategy is called the RRSP meltdown strategy.  

What is the RRSP Meltdown Strategy?

This strategy is a way to withdraw from your RRSP's tax free.  Typically, when you withdraw from your RRSP you pay tax on the withdrawal at your marginal rate.  With this strategy, there will be no tax owing.

How does it work?

Pretty simple actually, setup an investment loan and make the interest payments from RRSP withdrawals (equivalent to the interest payment).  Since the interest on the loan is tax deductible, the RRSP withdrawal taxation is canceled out.  This results in zero tax owing on your RRSP withdrawal.  The investment loan can be used to purchase dividend paying stocks to provide income during retirement which can be very tax efficient also.

Confused?  Say that you paid out $10,000 in interest on an investment loan, but withdrew $10,000 from your RRSP the same year.  The $10,000 from your RRSP is taxable at your marginal rate, but the $10,000 from the investment loan payments are tax deductible thus resulting in $0 tax owing.

Hopefully at this point, you are in a lower tax bracket, thus having a dividend based non-registered portfolio would be very tax efficient.  Note that if you have a very large dividend based portfolio, it may affect your Old Age Security (OAS) payout.  Dividends are grossed up (45%) which is counted as your income for OAS calculation purposes.

When should you do this?

I wouldn't suggest that someone go out and start withdrawing from their RRSP right away!  This strategy may be helpful for those who are closing in on retirement and are strategizing their RRSP withdrawals.  Remember, the earlier you withdraw from your RRSP, the more you reduce your tax deferred compound growth which can have a large effect on your portfolio value.  

Conclusions:

The RRSP Meltdown strategy is a great way to convert your RRSP into a non-registered income producing portfolio tax free!  I will be looking into this further when my time comes. :)

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 33 comments… add one }
  • The Financial Blogger September 17, 2007, 8:14 am

    This is an awesome technique, even for people who hates leveraging ;-)
    A while ago, I posted an example with calculations over 10 years. If you want to take a look at it:

    http://www.thefinancialblogger.com/rif-meltdown-strategy-a-complete-example/

    It is definitely a great way to avoid paying too much taxes on your RRSP!

  • FrugalTrader September 17, 2007, 8:17 am

    Hey FB, I had no idea that you posted an article similar, otherwise I would have linked to it! Great article btw.

  • The Financial Blogger September 17, 2007, 8:27 am

    Thx FT!
    don’t worry about the link, it was written back in may. In the blogosphere, if it was not written 2 weeks ago, it’s part of the archive, right? LOL!

  • Cannon_fodder September 17, 2007, 10:52 am

    Based on a client request, I created a calculator to demonstrate this concept. Previous to this, I had heard of the mythical “pay no taxes on RRSP withdrawals” but didn’t think much of it – kind of like a “too good to be true” idea.

    When I finished the calculator and started to play around with numbers I came up with a personal plan. For me, I would use this strategy *before* retirement to set me up.

    My goal would be to have enough dividend income generated from non-registered investment portfolios to carry me through retirement without ever having to touch the capital. In order to reach that critical mass sooner, I would use a portion of my RRSP holdings next year (to coincide with either a great buying opportunity or the renewal of my mortgage) to fund a separate investment loan’s interest payments for the next 10 years (new goal for retiring – 11 years from now). I say separate because I will be implementing the SM with Rempel Maximum as well.

    In 11 years from now, I would have depleted this portion of my RRSP savings but I would have an investment portfolio made up of blue chip dividend paying stocks which should support my retirement. However, I still would have that LOC sitting there begging for interest payments and my RRSP holdings are gone, right? Not so fast…

    I still would have my work-related RRSP’s which have significant company contributions – that is one golden goose I’m not messing with. It should allow me to fund the LOC for an additional 16 years after my self-directed RRSP has been depleted.

    If they are still around and I’m eligible, the CPP and OAS that I would have been collecting could fund the LOC interest payments until I die. If not, then I would divert some of the dividend income towards the payments. The good thing is that the interest costs would remain virtually the same but the dividend income, CPP and OAS (crosses fingers) should grow and grow and grow.

  • tom September 17, 2007, 10:53 am

    Another option is ti used borrowed money to buy a Corporate Class (CC) mutual fund that has a T-swp (say 5% withdrawal rate). Cash flowing from fund is ROC (once initial capital distributed, remainder is cap gains). Variety of CC funds available, balanced, dividend, bond etc. Only downside is MER’s for fund but these can be written off in some cases I believe.

  • nobleea September 17, 2007, 1:08 pm

    I assume the first year you did this would be a problem, since there would be a withholding tax on the rrsp withdrawal. You’d get it back the next year at tax time (which would overlap with the next years withdrawal). But you’d be out some money for the first year. No big deal I guess.

    I like this concept. If you did this for say 10 years, before retirement, you could use your RRSP withdrawals to pay the interest on the loan, and the dividend income to pay down the principal. Hopefully you’d have the yields and timeline selected such that the LOC could be almost completly paid off by retirement? Of course, as you pay down the LOC, your interest and thus RRSP withdrawals go down.

    Other option would be as Cannon_fodder suggested whereby the rest of the RRSP pays for the interest during retirement and you keep the investment loan principal for your entire life.

  • FrugalTrader September 17, 2007, 2:13 pm

    Cannon, remember that the earlier you withdraw from your RRSP, the more you negatively affect your portfolio growth. Also, if you setup your large non-reg div portfolio before retirement, your dividends will be taxed at a higher rate. Just some criteria to consider.

  • Cannon_fodder September 17, 2007, 6:06 pm

    FT,

    My overall portfolio growth would be larger with this process. This is because the money borrowed for investing would, in my particular case, be about twice the value of the RRSP’s. It would be possible to effectively draw from the RRSP’s forever if you drew out a smaller amount (to service a smaller LOC for the investments). Effectively, because at some point you probably would convert it to a RRIF and then you would be forced to escalate withdrawals.

    You are also right about the dividend income treatment. Although I don’t live in wonderful BC and their very generous treatment of dividend income, I still wouldn’t put myself in a position where I needed the dividend income until retirement. How I used the dividends might change along the way. The tax liability would grow over time and it might become so large that I couldn’t handle it out of pocket – I would thus not be able to keep reinvesting it but would have to actually use some of the payout to help pay the tax liability.

    Nobleaa is absolutely right – there is the withholding tax to consider. In my particular case the most that it would be is 10%. I would plan on having a buffer of money at the beginning of this process to help pay the difference in LOC costs. Once the tax refund came the following year, that would become the buffer for the 2nd year and so on and so on. My plan is to never pay down the LOC and, hopefully, never touch the capital until a really big need came up – like a beachfront house!

    You really need to run the numbers to see how this would work… especially if you will be doing the SM with Rempel Maximum, contributing to one RRSP and doing a meltdown on another. It is quite an eye opener to see your thoughts of a comfortable retirement appear sooner on the horizon.

  • Man From Atlantis September 17, 2007, 9:31 pm

    It can be difficult to measure the true value of this strategy because the simple math misses the impact on Government benefits, clawbacks and tax credits. It is a powerful strategy to convert 100% taxable income to capital gains or dividend income. Cannon Fodder has explaind it well.

    It would also be useful for those with LIRAs or LIFs who are wondering what to do with them. And of course – what better why to pay for the SM and RM?

  • WhereDoesAllMyMoneyGo.com September 18, 2007, 1:16 am

    For people with pensions – it is generally wise to save to non-registered accounts for retirement as opposed to having pension income AND RRIF withdrawals as well. Especially if you don’t need to make the minimum RRIF withdrawal to sustain yourself.

    The people who have a nice pension AND RRSP’s are going to be prime candidates for meltdown strategies! :)

  • Pauls September 19, 2007, 8:18 am

    Interesting concept.

    I find it odd in a forum where people have stated that they wouldn’t use Manulife One because of a $14 fee, to use leverage this freely. It’s risky, period.

    Why don’t you just invest in dividend paying stocks within your RRSP and save the money to invest each month?

    It’s also not mentioned in the article that you have to contribute to your RRSP each year…right?

  • Cannon_fodder September 19, 2007, 11:37 am

    Pauls,

    There would be no requirement to continue to contribute to RRSP’s while performing the meltdown.

    I also don’t think investing in dividend paying stocks within an RRSP is mutually exclusive to melting down an RRSP.

  • FrugalTrader September 19, 2007, 11:40 am

    Pauls, this article is not for the young person still building their RRSP. It’s a method of withdrawing from your RRSP, when you’re ready for retirement, tax free.

  • Pauls September 19, 2007, 10:04 pm

    FT:
    So the assumption is you have maxed out your RRSP or for some reason you have no income to be able to add more each year and get the tax refund? What am I missing? I know they are not mutually exclusive. But one method has you laying your future on the line with leverage.

    Let’s contribute to our RRSPs until we can’t anymore, use the tax refund to buy dividend paying stocks (or pay off a mortgage if you still have one). Boring I know.

  • Cannon_fodder September 19, 2007, 11:53 pm

    Pauls:

    There are no panaceas. So, this would not work for you as you are not comfortable with borrowing to invest.

    In my situation, I could start withdrawing from my self-directed RRSPs next year for example. I would continue to contribute to my work RRSP and, if it made sense, contribute to a new self-directed RRSP.

    I would borrow a significant amount to invest (in my case it would be twice the size of my current self-directed RRSP holdings) and invest that in dividend paying stocks as you suggest. I would withdraw enough from my RRSP to pay the interest on the investment loan.

    In 10 years, the situation would be:

    – a non-registered portfolio probably 5 times the size of my original self-directed RRSP
    – an investment loan about twice as big as my original self-directed RRSP
    – no original self-directed RRSP
    (the work and new self-directed RRSP should be unaffected by this strategy, although one could argue the investment mix might be different because of such a large non-registered portfolio. Let’s leave this aside for simplicity.)

    If I didn’t go through this process, the portion earmarked for meltdown would be about double what it is now and I would have no investment loan.

    I believe that the combination of a non-registered portfolio at 5x with the liability of an investment loan at 2x is worth more than a registered portfolio of 2x. In fact, I think a non-registered portfolio of 2x is worth more than a registered portfolio of 2x.

    Here are some numbers from my calculator:

    A $100k RRSP that grows at 8% annually will be worth about $215k in 10 years. But, you still would have to pay tax on the withdrawals.

    On the other hand, if you take out a loan today at 6.25% in the amount of $230k, then the interest costs would be around $1,200 / month. So, you take $1,200 / month from your RRSP to pay that loan’s interest (we’ve already discussed the issue with withholding tax). Ten year from today your RRSP is gone, but you have a $230k loan and a portfolio which, at 8%, grew to almost $500k.

    If for some reason, you decided you were going to take all of the money in either case to go buy that boat you’ve had your eye on, well in Ontario you would give up 46% of the RRSP and you would be left with $116k. In the meltdown case, after discharging the loan and paying capital gains taxes, you would have $205k – almost double the RRSP and in fact almost the same amount of the RRSP *before* taxes.

  • Andrew.Y January 24, 2008, 10:04 pm

    I don’t understand what make you think this strategy work??? it is because as i know, the interest you pay for the investment loan can’t be deduce by capital gain and normal income.

    so. your strategy is not working!!

    • FrugalTrader January 24, 2008, 10:14 pm

      Andrew,
      This is the way that the RRSP meltdown method works. When you withdraw from your RRSP, it is taxed as income at your marginal rate. If you get an investment loan, the interest paid is tax deductible. Thus, if you get a large interest only investment loan, and make the payments with RRSP withdrawals, the tax owing and tax deduction cancel out each other.

      This is not MY strategy, it is a strategy that is well documented by financial experts.

  • Andrew.Y January 24, 2008, 10:30 pm

    well, i am very comfused.
    this is the CRA’s page i see. i don’t know if i get it idea wrong or not.

    “…Most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid. ”

    url is http://www.cra-arc.gc.ca/tax/individuals/topics/income-tax/return/completing/deductions/lines206-236/221/menu-e.html

    • FrugalTrader January 24, 2008, 11:01 pm

      Andrew, yes, according to CRA, if you borrow to invest, you need “reasonable” expectation of income/profit. However, if you invest in a stock, there is a “reasonable expectation” that it “could” pay a dividend in the future.

      In addition to this, if you are at the point of withdrawing from your RRSP, it’s most likely that you’re in a lower tax bracket anyways. So if you put your investment loan towards dividend paying stock, it will be taxed very little.

  • layman February 11, 2008, 5:37 pm

    Its February 11th, I determined a contribution of 20,000 pays a 30.6% and 25,000 pays 30% using Ufiles Max Back calculator so which should I do?

    I have just sold my home and will be purchasing the rrsp off the “Canadian Tire One and Only Account” until completion on my home. I then intend to take a 2 year sabatical where my tax bracket will be lower. My question should I top up max (49,000) and withdraw at the lower rate now, should I set up a fixed rate sub account for this contribution and how do I find the dividend paying stocks?

  • Acorn February 22, 2008, 12:41 pm

    How about this scheme… Use RRSP to support an investment loan. Use this loan to invest in a “T” fund (as it was suggested – see comment #5). Receive distributions that are 100% ROC (tax free) . Use these monthly distributions, which generally will be LARGER than monthly RRSP withdrawal, to make a NEW RRSP contribution. So, instead of RRSP meltdown we have RRSP build up + a nice RRSP tax refund, which can be invested back in a “T” fund. Zero money from your pocket for this “Anti-meltdown maneuver” to grow your RRSP and support non-registered investments. Will it work?

  • Matt January 17, 2009, 5:15 pm

    Frugal Trader:

    Your technique is flawed. There is something called witholding tax, which you pay in addition to income taxes when you withdrawal money from your RRSP. The taxes do not cancel out.

    Best of Luck,

    Matt Noel

  • DK January 17, 2009, 11:29 pm

    Matt,

    The withholding tax is not “in addition” to income tax, it’s only an “advance” — so the CRA gets their money sooner (or more accurately: to make sure they get it at all and you don’t simply run off with the money). When you file your return the CRA calculates how much tax you owe versus how much was withheld and then credit or debit you accordingly.

  • cannon_fodder January 18, 2009, 3:39 pm

    DK,

    That’s right and in fact even the withholding tax is monitored for cumulative withdrawals. I had initially thought you could take out $5,000 amounts as often as you want and only have 10% withholding tax each time but it doesn’t work that way. That first dollar after $5,000 is taxed at 20%.

  • Bhangi January 19, 2009, 5:24 pm

    Not sure if any of you have considered a slight variation of this strategy. Instead of starting this strategy closer towards retirement, start it ASAP.

    1) Obtain an interest only investment loan and make the interest payments through RRSP withdrawls.

    2) Invest in Canadian Dividend paying stocks and use the dividends to decrease the principal.

    3) Every year, add additional funds to the RRSP account for obvious tax advantages. And since more funds are now available, have the loan amount increased accordingly and invest in additional Canadian Dividend paying stocks.

    4) Due to dividend growth, hopefully the income stream from dividends should be enough to support an early retirement 15-20 years down the road. At this point, stop contributing any further to the RRSP and exhaust the remaining RRSP funds towards the loan interest.

    5) In a few years when the RRSP has been depleted, the income should have achieved such levels where a retirement and loan interest should be covered. Any remaining income can be used to pay off additional principal.

    6) Keep enjoying an increasing income and it is up to your discretion as to how much want to contribute towards the principal to pay off the loan faster or keep the loan and make interest only payments, similar to the Smith Manouver.

    I have not run through the numbers but just wanted to throw this idea out there and get your input.

  • rick_k July 22, 2009, 2:45 pm

    frugal trader
    good strategy except for in quebec where the interest expense is adjusted since there is no interest earned

  • sam February 3, 2011, 5:46 pm

    I have a question for you. I am a new immigrant to Canada (immigrated in Sep 2009). My total income for 2009 was zero. In May, 2010 I got a job in a financial services company. My income for 2010 is $55,000 approx. My wife is a homemaker. We have a 2 year old. I want to open an RRSP account. My questions are: should I open an account for myself or my wife so that I can get the most tax savings? What is the maximum that I contribute for the year?
    Thank you for your help,
    Sam

  • Thomas Venner February 8, 2011, 5:01 pm

    Sam, which finacial services company do you work for? I would think you would have been given some information about RRSP basics ;)
    To answer your question, your 2010 contribution room is based on your 2009 income, therefore you have no contribution room. Did you file taxes for 2009? If so your notice of assesment (NOA) will tell you haow much contribution room she has. Did your wife have any 2009 income? If so her NOA will give your her 2010 contribution limit.
    Based on your income for 2010, you will have a contribution limit of 18% of “earned income” up to a max of just over $22k. Sposal or non-spousal the “tax savings” are the same. When you retire the spousal plan may have certain advantages depending on your retirement and pension situation.

  • Ansix12 June 1, 2016, 3:06 pm

    This comment trail has not been active for a long time. But I will post a question anyway. This approach is rather interesting. I have a holding company that was created for creditor protection purposes. My question is this, instead of borrowing the money to invest from the bank. Can I borrow from the holdco and pay interest to it instead? Or is the attribution rules make this not possible?

    Thanks

    Ansix12

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