We all know it’s important to save for retirement. If you plan to stop working some day, you’ll need income to support your lifestyle. For this reason, a lot of Canadians put the majority of their savings into a Registered Retirement Savings Plan (RRSP). There are several tax advantages to saving within an RRSP, but what happens if that’s your only form of savings? What happens if you need money before retirement?
Generally, you can’t touch the money in your Registered Retirement Savings Plan (RRSP) before retirement without having to pay tax on the total amount of the withdraw. Of course, there are some exceptions, such as buying a home ang going back to school. But what if those aren’t applicable. What if you need to get money out of your RRSP to fund your business, pay for living expenses or for a financial emergency? We’re here to let you know, there’s another way – with a RRSP meltdown strategy.
What is a RRSP meltdown?
A meltdown is a financial strategy that let’s you deregister your retirement savings in a RRSP or Registered Retirement Income Fund (RRIF) in a tax-efficient way. If you’ve always saved within an RRSP and don’t have non-registered investments, this strategy can help balance that out and reduce the amount of registered money you’re required to take out at the age of 71. .
With a meltdown strategy, you still have to pay tax on the amount of money withdrawn, but you can offset the income with a loan. Let us explain. If you take out an investment loan (i.e. borrow money to invest), the interest payments are deductible on your taxes which offsets the income you’ll declare from the RRSP (or RRIF) withdrawal. It’s a win-win financial strategy because you’ll invest the money from the loan, use the money from your RRSP withdrawal to make the loan payments and deduct the interest costs. This strategy is most efficient when the amount withdrawn from your RRSP or RRIF equal the interest payment on your investment loan.
The benefits of an RRSP meltdown strategy
The first benefit of an RRSP meltdown is lowering the amount of tax you’ll pay on your RRSP or RRIF withdrawals. Generally, it’s a good financial strategy to withdraw money from your retirement accounts earlier because your tax rate is presumed to be lower than it will be later in life during retirement. Since you need to declare and pay tax on any money withdrawn from your RRSP or RRIF, it’s better to do so when your personal tax rate is lower, so you pay less tax.
As an example: You have $2M in your RRSP at age 65 and by time you’re 71 the value is $4M. This is when you’ll need to covert your RRSP to a RRIF. Based on a $4M value, the minimum annual RRIF withdrawal amount would be $210,000. If you deregister the money with an RRSP meltdown strategy, your minimum RRIF amount would only be $105,000 because it would be based on the $2M. This will effectively reduce the amount of mandatory tax.
The second benefit of a meltdown strategy is the flexibility to use your retirement savings for reasons other than retirement income. Once the money is withdrawn, it’s deregistered and can be reinvested in more liquid, tax-efficient investments such as a Tax-Free Savings Account (TFSA). If you have a higher income, substantial retirement savings and don’t need the money in your RRSP – or have plans to use it, this strategy can help reduce the amount of taxes you’ll have to pay at 71 on your mandatory RRIF withdrawals.
The third benefit come with estate planning. If you don’t have a spouse or common-law partner, your RRSP and RRIF assets are liquidated at the fair market value (FMV) upon death and included in your final income taxes. If you have several assets, this can be very expensive because as your income increases, so does your tax rate. If the money is deregistered prior to death, you can leave it to anyone you like without your estate having to pay tax.
What’s the downside of an RRSP meltdown?
When you borrow to invest money, there’s always a risk of negative equity when the value of your investment is worth less than the outstanding loan amount. If you borrow $10,000 to invest and the value of your investment drops to $8,000, you now have negative equity. This can be a problem if you want to use the asset to repay the loan because you won’t have enough and will need to pay out of pocket.
Another disadvantage is regardless of the value of the asset, the loan must still be repaid. In extreme cases, you could find yourself in a situation where the value of your investment is zero, but you still have an outstanding loan balance to repay. For this reason, high risk investments should generally be avoided when borrowing money to invest. An RRSP meltdown can be a complicated financial strategy because there are a lot of moving pieces – factors to consider. It’s best to talk with a financial advisor to make sure it’s a good solution for your personal financial situation.
For more information on withholding tax, including tax rates per province, visit Canada Revenue Agency.
If you want to discuss your retirement plans and see if a RRSP meltdown is the right strategy for your needs, contact us. Let’s talk about your income, investments and retirement savings.
