In Part 2, we discussed a sample, complete meltdown. We found that it might be much too risky. Let’s now look at some alternatives…
WHAT ABOUT A TERM LOAN?
This is complicated. If you were planning on withdrawing money from the non-registered account for living expenses – this strategy will flat out not work! Allow me to explain:
Using a 10 year term loan for HALF the value of the RRSP (as opposed to an interest only loan and completely melting down the RRSP) requires us to point out a few items: With a term loan the amount of interest will be less than the RRSP withdrawal annually so there will be some tax owing. This is because the term loan payment is part interest and part principal. Since we did not use any “surplus cash flow” in the above scenario, it wouldn’t be fair to just assume that our investor can make up the shortfall in this scenario caused by the tax on the RRSP withdrawals that are not offset by deductible interest. Therefore, he will have to pay for the extra tax by redeeming even more of his RRSP! :) (This is the main reason the strategy won’t work).
Also, with a term loan, the interest makes up about half the loan payments in the first year, but in the last year only makes up about 7% of the loan payment – so his tax bill goes up every year, meaning he has to redeem more and more money out of his RRSP each year until the loan is paid off!
I created a spreadsheet to figure out the impact of the increasing redemptions to the RRSP on top of the static annual loan repayments of $25,057, and the rate of growth of 8% on the funds annually. I’ll spare you the math: the RRSP value after 10 years is almost exactly $200,000 even.
So now let’s check on the value of the $175,000 invested into the non-registered account (this is half of the RRSP’s value at the start of the 10 years). This one is pretty easy as we just have to take the lump sum and grow it at 8%/year which gives us: $377,800 (rounded). Unlike before, we don’t have a loan balance to pay off as we have been paying it off all along.
So in this case we have $200,000 in the RRSP and $377,800 in the non-registered account at age 65.
To figure out the combined net income after tax if our investor were to withdraw the funds annually such that both accounts would deplete to zero by age 90 would allow for… $34,937/year after tax? That is below the after tax annual amounts for a full meltdown AND if we didn’t meltdown at all ($43,341/year and $36,025/year respectively). What gives?
Well, if you’ll remember we took out a term loan of $175,000 over 10 years. That means that $175,000 of the payments over the 10 years was just PRINCIPAL – which cannot be deducted. Over the years that also added up to around $140,000 in extra tax owing. These drains are just too much to overcome for this strategy to be effective…
Does the RRSP Leveraged Meltdown work? In theory, yes it does, but only if you expect to be comfortably in the highest tax bracket throughout retirement. If your RRSP is the only source of retirement income (asides from CPP and OAS) then a meltdown would probably never make sense.
If you do fit the criteria of being comfortably in the top tax bracket, keep in mind that in the real world the risks involved are so great that I have to re-iterate that it is probably only suitable for the most speculative of investors (and even then it seems questionable)! If you are interested in this strategy, as always, make sure to check with your financial advisor to make your own determinations, but also remember that they might be more inclined to promote the strategy as it would mean they get to manage more money (and hence generate more fees).