Continuing from Part 1, I mentioned that I would look more closely at leveraging a meltdown. I already stated that I think it would be pretty rare for someone to want to completely meltdown their RRSP and focus on offsetting the withdrawals with deductible interest since the risk involved in doing so would be fairly high, and the loan value enormous. From the calculations I made below (which don’t even factor in variance of actual returns in the real world!) the risks in this strategy are too great for all but the most speculative investors.
(SIDE NOTE: My post got so long that I’m deciding to increase the series to three parts – it was originally penned for two parts.)
Let’s look at what would be involved in completely offsetting the RRSP withdrawals with interest on an investment loan. First we need to make a few assumptions:
1. Our investor is 55, will retire at 65 and will live to 90.
2. He has $350,000 in his RRSP.
3. All his investments grow at 8%.
4. His loans are charged 7% in interest.
5. His marginal tax bracket is 45%.
6. He has other sources of income in retirement such that the income from his RRSP will all be taxed at his marginal rate.
If he wanted to completely meltdown his RRSP by the time he retires that gives him 10 years to melt down $350,000 that is growing at 8%/year. That means he would have to withdraw $48,300 (rounded) per year in order to have $0 in his RRSP by age 65.
If we tried to offset $48,300 in taxable income with deductible interest from an investment loan we need to calculate how much the loan principal would be to support that. Assuming an interest only loan and working backwards we find that $690,000 at 7% per year equals $48,300. That’s one heck of a loan!
Fast forward to age 65. Now our investor has $0 in his RRSP, but his non-registered investment has grown from $690,000 to $1,490,000 (rounded, growth at 8%). Since the RRSP is now depleted, we can no longer afford the interest on the loan so we will have to collapse the leverage. If we subtract the loan principal of $690,000 this leaves us with $800,000. But don’t forget that in order to pay off the loan, we would have to sell some of the investment which would incur tax. So if we sold $690,000 (and to be conservative let’s assume the whole amount is a capital gain) then there would be an additional tax bill of $155,250. Once this is subtracted from the $800,000 we are now left with $644,750.
Let’s go back and see what his RRSP would have grown to by age 65 if he had not made any withdrawals: At 8%/year we have $755,623. So looking at the absolute values, it looks like the non-melted-down RRSP is actually better – but…
To be thorough, we should look at how the ongoing withdrawals are taxed (to see how much he would have to spend) if we depleted both accounts to $0 by age 90.
For the non-melted-down RRSP, $755,623 growing at 8%/year and being depleted to $0 by age 90 would allow for annual withdrawals of $65,500 (rounded). If they are taxed at 45%, then his net income per year would be $36,025 (rounded).
For the meltdown, the non-registered account of $644,750 would allow for annual withdrawals of $55,925. Again being on the conservative side, let us assume that ALL withdrawals are realized capital gains and therefore 50% of the withdrawals are subject to 45% tax. In this case, the net income per year would be $43,341 (rounded). That is a sizeable advantage of $7,000+ per year in his pocket versus the non-melted-down RRSP!
(For those who are interested in seeing the after tax effects if the RRSP or melted down RRSP was the ONLY source of retirement income, or in other words if his marginal tax bracket didn’t apply to the full amounts, then I calculated the net income [including OAS Clawback] as follows for each: non-melted-down RRSP=$56,721, melted-down RRSP=$52,502; these figures may seem artificially high compared to the results above, but this is because I ADDED CPP AND OAS to these numbers since it makes a difference if we are calculating THROUGH multiple tax brackets. For the above numbers, if those income amounts were indeed taxed entirely at 45% then the tax on their CPP would be equivalent and their OAS completely clawed-back.)
Okay, so we’ve seen that a leveraged meltdown works in theory for those who will be very much in the highest tax bracket in retirement. But look at the assumptions that we have made! Our investor had to take out an interest-only loan for $690,000! We also assumed that he would generate a static 8% rate of return on all his investments.
In practice, this person might have difficulty getting approved for an interest-only loan for $690,000.
Further, the risk in this strategy is enormous. The first few years will make or break you in a big way. If there were a bear market near the beginning of this strategy, consider that not only will your leveraged investment’s balance look scary, but the odds of being able to keep up with the RRSP withdrawals while your RRSP is experiencing negative growth greatly diminish. If you ran out of funds in your RRSP, you might also be under water in your leveraged investment. That’s a serious double whammy!
Let’s see what happens when the market only provides your portfolio with a 5% return:
1. Your RRSP would be depleted at around 8.5 years.
2. At that time your leverage would be worth $1,045,000.
3. You would no longer have funds to withdraw from your RRSP to pay the interest on the leverage so you would have to collapse the loan.
3. After paying off the loan of $690,000 that leaves you with $355,000.
4. After paying the tax for that, you are left with about $200,000!
Alternatively, if you just let your $350,000 RRSP grow at 5%, at 8.5 years in you would have about $530,000.
Hmmm… $530,000 with no leveraged meltdown versus $200,000 WITH a leveraged meltdown if the markets only return 5%… Can you see how much risk is involved with a completely offsetting leveraged meltdown??? From an earlier post you’ll note that the lowest 10 year rolling average rate of return on the TSX was 3.3% so even if you had what it takes to buy and hold, yes you could “make a positive return” but the chances (to me) of having a rate of return LOWER than the interest charged on your loan are PRETTY GOOD. Too good in fact to make a strategy like this endorsable to all but the most speculative of investors.
In Part 3, we will look at what happens if we take out a term loan instead and didn’t completely meltdown the RRSP…