If you have been successful over the years with your RRSP investments, you may have built up substantial amounts in those registered accounts.
That's obviously much better than the alternative of poor investments and no growth. Successful RRSP investors have used the tax sheltering of an RRSP to maximum benefit. As well, many RRSP contributors have also been able to reinvest the tax saving from their contribution each year to add to their savings capacity, thus growing the RRSPs at a much faster rate than they could with non-registered investments.
But approaching retirement with a large RRSP can present its own challenges, especially if most of your retirement assets are a combination of registered assets in RRSPs and pensions.
All withdrawals from any of these plans are fully taxable. If your total individual income in retirement will exceed $70,000, then any additional withdrawals will be taxed at nearly 40 per cent in most provinces. In addition, 65-year-olds will have 15 cents of every dollar of OAS payment withheld for every dollar of net income over $67,668.
That can mean an effective tax rate of almost 55 per cent. So it's no wonder a scheme that purports to be able to allow people to withdraw their RRSPs without tax attracts a favourable response from investors.
Such a plan is often called the "RRSP meltdown" strategy.
There are actually two types. The first uses sleight of hand, tax-rule violations or inflated donation-receipt charitable scams as their basis. I simply tell you, "Don't do it."
The other strategy is within the tax rules, but has risks associated with it, of which you should be aware. This plan involves borrowing money to invest in qualifying investments, which makes the interest on the loan tax-deductible. This interest deduction offsets the taxable withdrawal from the RRSP and reduces net income for OAS clawback calculations.
A potential benefit (but potential risk) is you also have a portfolio of investments that can grow.
Example: If you want to offset a $10,000-a-year RRSP withdrawal, you would borrow, perhaps, $200,000 to invest. At a five per cent loan interest rate, you would pay $10,000 a year in interest, essentially making the RRSP withdrawal tax-free and OAS clawback-free.
But who's paying the interest? Isn't that an additional cost?
The person promoting the plan would tell you the investments you buy with the loan will generate five per cent and thereby cover the interest cost.
Well, that may be true, or it may not. What's likely is that a portfolio of stock investments, or a balance of stocks and bonds, will earn more than five per cent some years and less in other years. As well, some of that income will be taxable.
If properly executed, with a minimum time frame of five years and careful investment selection, this could work out well. If, for example, the new investments earn eight per cent a year over the five-year period, you will have capital growth and positive cash flow over the five years.
On the other hand, if you have a five-year period of flat growth (as happened twice in the last 13 years), or if you chicken out when there is a market correction and sell at a loss, the entire strategy could backfire.
Financial advisers with life insurance licences may suggest a much more complicated strategy involving the purchase of life insurance, simultaneously borrowing back the life insurance premium payment and excess deposit to invest in a separate investment portfolio.
Such a strategy can work, but I would only recommend it if permanent insurance is required and you are comfortable with significant complexity and a small amount of CRA audit risk.
We look at all of these strategies on behalf of our clients, and occasionally find a situation where all of the components are in place to make it attractive for the client. But one thing I've learned in my years in this business is many people are happier in the long run if they pay a reasonable amount of tax along the way, to avoid surprises and potential bad outcomes.
David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).