You’ve probably thought about the best way to get money into your RRSP, but have you thought about the best way to get your money out? If you haven’t pondered this issue, you should. Otherwise, you could run headfirst into a nasty tax bill.
The people who get swiped the hardest are diligent savers. They’re so successful at preparing for retirement that they don’t need to tap their RRSPs the moment they hit 65. They just let their money sit there. Then they’re surprised to discover that when you turn 71, the government forces you to start withdrawing money from your RRSP, whether you want to or not.
What really stings is that you have to pay taxes on the money you withdraw. If you have a seven-figure RRSP, or if your total income is high because of other investments, you could lose more than 40% of your hard-earned RRSP savings to the taxman. Nothing incenses a 71-year-old more.
The good news is that you can avoid this problem by implementing an RRSP “meltdown strategy” long before you hit your 70s. Here’s how.
Filling the tax holes
A simple strategy is to plan ahead and keep your retirement income as consistent as possible. It sounds strange, but what you really want to avoid are years when you have a higher income than you need. That’s because you’ll pay a higher percentage of your income in taxes during those years, and you don’t get that money back.
The best plan is to look for years when your income will be low, especially as you transition out of full-time work. You may even want to deliberately create a couple of such years by retiring a bit early. Those years are your “tax holes,” and you can use them to shovel money out of your RRSP at a low tax rate. That doesn’t mean that you have to spend the money you just want to get it out of your RRSP at the lowest tax rate possible.
Flow-through to low taxes
If filling in the tax holes still leaves more money than you need in your RRSP, it may be time to start looking at tax deductions.
David Shymko, partner at Macdonald, Shymko & Company, a fee-only financial planning firm in Vancouver, says a popular strategy among his clients is to use flow-through shares. These are issued by certain mining and petroleum companies and allow you to write off what’s called the Canadian Exploration Expense. In some cases, says Shymko, you can get a deduction that’s so large, you don’t pay taxes on your RRSP withdrawals at all.
A year or so after the deduction has been claimed, you can cash out of your flow-through investment and put the money into dividend-paying stocks, such as those of the Canadian banks. Because of the dividend tax credit, you’ll pay less tax on the income you get from your dividend portfolio than you would pay on money you withdraw from your RRSP.
Pile on the debt
When you borrow money to buy certain types of investments, you can deduct the interest payments from your taxable income. So if you borrow a large sum of money from the bank and make the interest payments with your RRSP withdrawals, you get a deduction. You can use that deduction to help offset the income tax you would otherwise have to pay on the RRSP withdrawal.
Ted Rechtshaffen, former president of TriDelta Financial Partners in Toronto, says the best way to make this strategy work is to borrow the money in the form of a mortgage on your house, because such loans tend to offer the lowest interest rate. You then invest the borrowed money in a portfolio of dividend-paying stocks, trusts and preferred shares. Rechtshaffen says that if you get a yield of 4% or higher on your portfolio, you can usually offset the interest charges. If your portfolio provides a return of just over 7%, you also eliminate the taxes on your RRSP withdrawals.
This plan is a good option for couples who will probably leave a significant sum in their RRSPs when they pass away. In that case you want to get the money out of there, because whatever’s left in the RRSP will likely be subject to a tax rate of 40% or more.
Shymko, who has over 30 years of experience as a financial planner, says the strategy works if it’s implemented properly by a professional, but he has yet to convince a single client to use it. Most people in their 70s just don’t have the stomach for the risk involved. “Clients always say ‘I’d rather pay the tax. I know my heirs will get a lower amount, but at least they’ll get something for sure.’”
Ultimately it’s up to you. While paying tax is never pleasant, you can at least take comfort in the thought that a bulging RRSP is one of life’s nicer problems.