# Melting down RRSP's



## ethos1 (Apr 4, 2009)

Can it be done effectively including minimizing the tax impact - are there ways to do it, if so what are they?


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## FrugalTrader (Oct 13, 2008)

ethos1 said:


> Can it be done effectively including minimizing the tax impact - are there ways to do it, if so what are they?


Ethos, the RRSP meltdown is to basically to take out a large investment loan and use RRSP withdrawals to service the investment loan interest. The tax on the rrsp withdrawal is negated by the investment loan tax write off.

More about the RRSP meltdown strategy here.


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## Preet (Apr 3, 2009)

*LONG answer Part I*

I've written before that there are some situations in which you would want to avoid saving too much to your RRSPs. In one way or another, the reason comes down to taxes. 

The most common reasons cited for monitoring the value of your RRSPs:
1. Withdrawals are subject to your full marginal tax rate.
2. Registered withdrawals add to your earned income.
3. If your income is too high it may trigger clawback of your Old Age Security benefit.
4. You are required to make minimum annual withdrawals from age 72 onwards even if you don't need the money.
5. Non-Registered assets can be taxed much more preferentially (while living and at death).

Because of these main reasons, strategies have been developed to shift assets from registered accounts to non-registered accounts - these are known as meltdown strategies. Before I continue however, don't forget that many people would be envious of your problem! 
There are actually two basic ways to melt down an RRSP. One involves simply withdrawing money from your RRSP while you are in a lower tax bracket and the other involves offsetting the RRSP withdrawal with tax deductible investment loan interest. Most people will marry the moniker of the "RRSP Meltdown" (or RRIF Meltdown) with the strategy that involves the investment loan - but the straight withdrawal method is also considered a meltdown.

1. Straight Withdrawal Meltdown
This strategy mostly applies to higher net worth individuals who do not need to access the funds in their RRSP accounts for their retirement living expenses. In this strategy, you are simply withdrawing funds from your RRSP early and re-allocating them to a non-registered investment account where the funds will continue to grow (albeit taxed on a yearly basis for interest, dividends and distributed capital gains). The hope is that you will save tax on your terminal tax return since you had slowly converted assets from being fully taxed at your marginal rate to assets that are only taxed on the growth (and hopefully most of that growth was in the form of capital gains thereby further reducing the tax bill).
You can see that this strategy really fits only a few situations in real life - namely because it assumes that the money in the RRSP isn't needed for your living expenses, but is rather earmarked as an inheritance (for a non-qualified beneficiary – See Strategy 38 – Naming a Proper Beneficiary for Your RRSP).
Up until a few years ago, for this strategy to really make sense would depend on you NOT living too long as the extra growth afforded by the tax sheltered RRSP eventually offset the extra taxes owed by the RRSP. Since your death is mostly an unknown variable, you wouldn't know if the strategy would have played out in your favour until you were on your deathbed. These days, we have more tax-efficient investments available for non-registered environments so the appeal is starting to come back.

2. The Leveraged Meltdown
The RRSP Meltdown strategy that everyone is normally referring to is this one. This is where you take out an investment loan in a non-registered investment account and the interest payment on the loan is used to offset the RRSP withdrawal (the interest on an investment loan MAY be tax-deductible if the investments are held in a non-registered account).
I usually see examples that propose the interest on the loan be equal to the RRSP withdrawal which allows for a zero-sum tax event. For example, assuming you are in a hypothetical 40% tax bracket your $10,000 RRSP withdrawal would be deemed to be earned income in the amount of $10,000 - which would be subject to $4,000 in tax. BUT, if you had paid $10,000 in interest on your investment loan that year then you would have an offsetting income deduction of $10,000 which would cancel out the $10,000 RRSP withdrawal's effect on your tax return.
But consider that to have a $10,000 interest payment you would need an interest-only loan of about $143,000 (assuming 7% interest charged on the loan). To have a $10,000 interest payment on a term loan would necessitate an even larger loan amount since part of your payment will be a repayment of principal.
While most people will promote the strategy with perfectly offsetting interest and withdrawal amounts - it is not necessary - and usually not practical.
The people using a leveraged meltdown strategy are trying to reduce the amount of tax they pay while they are living and as such, they want to slowly shift assets from being in a registered environment to a non-registered environment. Also note that you don't have to completely meltdown your RRSP to $0 either. It really will come down to a number of factors (such as rate of return, longevity, asset allocation, projected annual incomes, etc.).
You should consider consulting with a professional to see if either of these strategies even make sense for your own situation first, but then also to see to what degree you need to implement them. Also be cautious that the advice is genuine as if your advisor is paid based on the assets he/she manages this creates a conflict of interest since this will increase the amount of investment assets you hold with him/her.
Very often, leveraged meltdowns only work if "all the stars are aligned". From the analyses that I had made, there are very few situations that justify taking on the amount of risk involved with interest-only leveraged meltdowns.

Also, it is worth pointing out that a third alternative exists: RETIRE EARLIER! 

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.

Complete Offset
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!


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## Preet (Apr 3, 2009)

*LONG answer Part II*

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.
4. After paying off the loan of $690,000 that leaves you with $355,000.
5. 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??? The lowest 10 year rolling average rate of return since 1950 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.

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... (at least for our test case)

Final Thoughts
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).


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## mfd (Apr 3, 2009)

great post Preet. Thanks a bunch


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## archanfel (Apr 7, 2009)

I tried to keep all my fixed income asset in my RRSP. Both for tax shelter and to prevent the RRSP from growing too large. A good reason to melt down RRSP is to leave the country and become a non-resident. Non-residents pay 25% taxes on OAS and CPP. However, the money would go much further in certain countries.


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## ethos1 (Apr 4, 2009)

archanfel said:


> I tried to keep all my fixed income asset in my RRSP. Both for tax shelter and to prevent the RRSP from growing too large. A good reason to melt down RRSP is to leave the country and become a non-resident. Non-residents pay 25% taxes on OAS and CPP. However, the money would go much further in certain countries.


non-resident rule is 2-years, so for withdrawl at 25% you could leave December this year 2009 then as early as January 2011 (making it two calendar years that you were a non-resident at the end of each year) go ahead to withdraw the RRSP's at the lower tax rate.

Unless you have good reasons to do & see it as a true benefit, or should plan never to come back to Canada, IMO, it just ain't worth it

One other consideration to keep in mind is that the OAS will not be indexed if you plan this as a permanent move away

The other is the residency rule with regard to provincial health care which you will have no access to after being away 6-months, putting you back to the 3-month waiting should you decide to return home here & that is why some snowbirds return before the 183 day rule before heading off again


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## johnsazzr (Apr 20, 2009)

mfd said:


> great post Preet. Thanks a bunch


+1


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## ethos1 (Apr 4, 2009)

Preet said:


> I've written before that there are some situations in which you would want to avoid saving too much to your RRSPs. In one way or another, the reason comes down to taxes.
> 
> The most common reasons cited for monitoring the value of your RRSPs:
> 1. Withdrawals are subject to your full marginal tax rate.
> ...


Preet, that was long but was very good, which cleared up a lot of unanswered questions for me.

I have edited the post to a summary & have some comments & a question

1. The high marginal tax on RRSP withdrawals - not too happy about that one

2. The idea of the leveraged loan, which is really a wash & risky when you consider that you are giving away interest money for money taken out. These days loan rates are really low as is the low risk investments which you would need to take a very large loan to cover a minimal amount of RRSP withdrawal - say $5k

Is it possible or advantageous to meltdown using the flow through share (FTS) approach?

Example: Taking $50k out from the RRSP which after 20% witholding tax you'd put the $40k into FTS. This gives you 100% write off against the RRSP income, leaving you with a 20% tax credit

On maturity or expiration of the FTS the tax works out to approximately 20% (tax on 50% of the gain)

Understanding that there are no guarantees on FTS or SFTS return on the investment, is this a possible other approach?

Comments would be appreciated


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## Preet (Apr 3, 2009)

ethos1 said:


> 1. The high marginal tax on RRSP withdrawals - not too happy about that one
> 
> 2. The idea of the leveraged loan, which is really a wash & risky when you consider that you are giving away interest money for money taken out. These days loan rates are really low as is the low risk investments which you would need to take a very large loan to cover a minimal amount of RRSP withdrawal - say $5k
> 
> ...


1. Join the club!  TFSA changes lots, though.
2. Yes, lower interest rates require larger loans in order to generate the offset desired for a meltdown. (More risk)
3. Using FTS - clarification: You can take out $50,000 from your RRSP, but will be subject to withholding tax of 30% (this is the default rate on withdrawals $15,001 and above). Means you have $35,000 to put into FTS. Assuming a 45% MTR, you might generate tax savings of $15,750.00. Assuming that the FTS breaks even by maturity, the entire amount is a capital gain (flow through credits reduce ACB to zero, if I'm not mistaken). So upon maturity you have tax at MTR on $17,500 which equals $7,875. Total tax paid to de-register, invest in FTS and then spend proceeds is $7,125 + the balance of the 15% of $50,000 that you didn't pay because the de-registration withheld only 30% and not your MTR of 45%. So it doesn't work.


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## steve41 (Apr 18, 2009)

The issue of not allowing your RRSP to grow too large because it will be subject to major taxation after age 71 never seems to go away.

If you are going to analyze the problem, you have to include not just a tax rate, but the complete progressive taxation algorithm (over time). Remember, 1) tax rates are reduced in retirement (age credits), 2) the tax brackets are indexed, (which means that whereas tax on $50K is close to $10K, in 50 years time at 3% inflation, tax on $50K will be just $3.5K), and most importantly, 3) you have to look at tax, not as a raw number, but as its present value. The trade-off is an immediate tax refund offset against a far term tax hit... it is not a calculation for the faint of heart.

Generally speaking (for someone looking to live to a reasonable age) the most tax efficient plan is one in which the present value of all future tax pmts is minimized. Tax can't be looked at as a single average or marginal rate or factor... it has to be integrated into a financial plan to the same level of detail you use when you do your T1. I have examined many financial plans, and in very few situations (unless you do creative gaming with leverage), have I been able to make a case for not sheltering and/or not maximizing your RRSP.

There is one exception, however....since last year, a case can now be made to preferentially contribute to your TFSA before maxing your RRSP. The advantage is not extreme, however.


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## archanfel (Apr 7, 2009)

steve41 said:


> The issue of not allowing your RRSP to grow too large because it will be subject to major taxation after age 71 never seems to go away.
> 
> If you are going to analyze the problem, you have to include not just a tax rate, but the complete progressive taxation algorithm (over time). Remember, 1) tax rates are reduced in retirement (age credits), 2) the tax brackets are indexed, (which means that whereas tax on $50K is close to $10K, in 50 years time at 3% inflation, tax on $50K will be just $3.5K), and most importantly, 3) you have to look at tax, not as a raw number, but as its present value. The trade-off is an immediate tax refund offset against a far term tax hit... it is not a calculation for the faint of heart.
> 
> ...


I think you misunderstood my statement. "not allowing your RRSP to grow too large" does not equal to "not maximizing contribution". It has more to do with asset allocation than contribution amount. 

For capital gains, unlike TFSA, RRSP does not shelter taxes. It only defer the taxes. Moreover, any taxes deferred will be charged on 100% of the gains rather than 50%. Passive equity portfolios do not pay taxes on capital gains each year anyway. Therefore, they should be done through unregistered account while RRSP should be used for fixed income investments. 

The main counter argument is that RRSP is locked in for long term, therefore short term investments should be in unregistered account. However, since I have no intention to access my fixed income investments any time soon, that's not a problem for me.


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## steve41 (Apr 18, 2009)

Again... unless you actually examine the numbers, even the deferred capital gains (equity) strategy doesn't necessarily work either.

Take a 40 yrold earning 65K, with 200K in his rrsp and retiring at 65.

Let's say that at age 70 he needs a lump sum 180K (after tax) in excess of his normal lifestyle. If he pulls it out of his RRSP, he suffers a big tax hit, driving him into the next mtr.

Now, what would happen if he anticipated that special need at 70, ahead of time (now, say). So, instead of continuing to invest in his RRSP, he starts to save (4000 a year in a deferred capital gains entity which grows tax free such that at the point of his special need, he can extract the lump sum without any extra tax hit (due to the 50% capgains tax reduction)

Now... when you look at the total tax he pays over the life of his entire plan, the 'equity' strategy invokes 1.13M total tax and the rrsp strategy 1.24M. Looks like the equity strategy wins, right? Well, no. When you look at the present value of all those tax pmts, the rrsp strategy invokes 292K tax (pv-ed) and the equity draws 296K.

These aren't drastic differences, but it shows that even when comparing tax efficient savings (capgains or dividends) maxing the RRSP still has an advantage.


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## archanfel (Apr 7, 2009)

steve41 said:


> Again... unless you actually examine the numbers, even the deferred capital gains (equity) strategy doesn't necessarily work either.
> 
> Take a 40 yrold earning 65K, with 200K in his rrsp and retiring at 65.
> 
> ...


Again, I was talking about asset allocation, not contribution.


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## Jon Chevreau (Apr 4, 2009)

Some stuff on the pitfalls of leveraged RRSP meltdowns on my blog yesterday, including comment from Preet!

http://network.nationalpost.com/np/...sp-meltdowns-could-jeopardize-retirement.aspx


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## hboy43 (May 10, 2009)

Hi:

My strategy is to have zero employment income, lots of dividends, leverage for interest deductibility (and more dividends). Then I have to take additional income from somewhere to drive my taxation up to about $1000 per year. I have rental income of about $10,000 per year, but the additional "somewhere" is usually capital gains. Last year and this year there were (will be) no capital gains, so some RRSP funds get out. Last year about $20,000, this year I estimate about $15,000.

I have about 25 years to get the rest of my $150,000 RRSP out before forced withdrawls apply.

The key to my scheme is of course declining to be a wage/taxation slave. I do plenty of work, just not of the kind that attracts taxation. We heat with wood harvested on our own acreage, about $4000 a year after tax if we used an alternative heat source, oil or propane. I do all the building construction and maintenance, this has to be $10,000 to $20,000 a year after tax. I grow some of our food, maybe $200 a year. I cook at home above the average household using raw ingredients instead of buying much processed food.

Anything I do for myself I get 100% of the effort. Anything I do in the economy, I only get 50% of the effort. I keep much fitter and healthier, eat better, and I no longer have to worry about making a professional blunder that costs my employer $100,000 in the blink of an eye. Of course, there are other trade offs, I don't take $10,000 annual vacations either. But then why would I want to, I live in my own park and I don't have job stress.

hboy43


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## cannon_fodder (Apr 3, 2009)

Preet, I have several questions:

1 - Why would we assume that this person wants to deplete their RRSP in 10 years? Why not at least until they turn 71 before the regulations will 'entice' that person to convert to an annuity, RRIF, etc. 

2. Why deplete it at all? By going with a lower amount it helps offset the argument that the risk is too great. Let's try something around $2050/month which will give rise to an investment loan about the same value as the RRSP ($351,429 to be exact). In this manner, the RRSP could potentially (if the timing is right) never be depleted until forced to. In fact, one could adopt the 4% rule and only take out an investment loan which would require RRSP withdrawals in line with 4% of the RRSP's value annually. (A $200k loan would require about 4% withdrawals from the RRSP.)

3. Why give detailed numbers (down to the dollar) then assume that all non-registered withdrawals are full capital gains? That is a very skewed way of looking at things which certainly makes the case weaker to adopt a leveraged meltdown strategy. It is one thing to say that the entire loan paydown is all capital gains but to compound this flawed premise by stating that all withdrawals during retirement are also subject to 100% capital gains treatment is difficult to understand.

4. What supports your assumption of a lending rate of 7%? In the last decade, a secure HELOC could be obtained for less than that, but going out further it was quite higher. There are margin accounts where interest rates may be even more favourable. Certainly a wide range of possibilities so I'm wondering why you chose 7%.

What about trying this...
RRSP - $350,000
Growth Rate - 7%
Interest Rate - 7% nominal (7.229% effective)
MTR - 30%
Investment Loan - $180,000
Period - 10 years before retirement, 25 years after.

Why 7% growth rate? Because in this scenario we have a 35 year time frame before everything goes to zero. I don't think 7% CAGR over a 35 year period is too much of a stretch.

RRSP grows to $688,503 if we don't touch it for the first 10 years.

RRSP grows to $508,720 if we withdraw enough to satisfy interest payments on investment loan. Investment portfolio grows to $354,087 in the first 10 years.

If we withdraw a steady amount from the RRSP in order to collapse it 25 years later, we can realise an after tax annual income of $41,357.

If, in the meltdown scenario, we withdraw from the RRSP and the investment portfolio and pay down the interest loan (with ever dwindling tax refunds) we get an after tax income from the RRSP of $30,557, an after tax income from the investment portfolio of $27,142 (I rigged it so that the before tax income would increase but the after tax income would stay the same - a bit tricky at first) and the investment loan will require $15,766 in annual payments with dwindling tax refunds. Thus, the total cash flow starts at $45,837 and ends up at $42,253 by the time everything is at zero.

Perhaps the point is that while those in higher tax brackets are more likely to realise the benefit of this process, it is not exclusive to them. You also would not want to embark on this meltdown too late (the longer time frame you have, the more likely you will see positive returns) nor when the market is overheated.

It was an interesting exercise and one which may come into play for those people employing the Smith Manoeuvre as they will likely have a significant HELOC and a non-registered portfolio. Using either RRSP withdrawals or even government pensions (OAS, CPP) to continue to just make the interest payments for the SM HELOC might be a very fruitful strategy.


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## Preet (Apr 3, 2009)

@Cannon Fodder:

Thank you for your comments and questions.

We can test out infinite variables. The attractiveness of this strategy will probably still range from not very to moderate. Throw in sequence of returns risk, perhaps use a monte carlo analysis or other such analysis (not everyone is a fan of monte carlo) and the risk of the strategy is just not warranted.

Why don't you run the scenario with non-leveraged investments incurring little tax and let us know what you find out? (I'm being lazy here, and my original data is on another computer). 

As for 7% for the interest rate, I just picked what I thought was a long term average. I perhaps erred on the high side, but again feel free to run the numbers with lower and higher interest rates and let us know what you find out.

At the end of the day, the strategy involves way too much risk for the average investor to even bother considering. Real world and theory are also different things. Ask anyone who engaged in this in the last 5 years - not happy I'll bet, but the projection from their advisor probably looked good at the time...

Of course, most people are pitched these strategies as a tax saving mechanism first, with investment selection and real world variability coming in a distant second and third.


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## cannon_fodder (Apr 3, 2009)

Preet,

Please let me know if my logic is flawed...

In the example you posted, a $690,000 loan was taken out and invested. After 10 years it grew to $1,490,000.

Let's assume $690,000 is the ACB. If I want to discharge the loan, I have to take out more than $690,000 because there is going to be a tax bill on it. My calculations work out that you need to sell:

$690,000/(1 - 45% * ($1,490,000 - $690,000)/$1,490,000 x 1/2) = $784,809. 

Thus, you are left with $705,191 as opposed to around $644k as you posted earlier.

I couldn't find a calculator online that figured out how to drawdown an investment portfolio and provide constant, inflation adjusted after tax income - so I created one myself. (It will be posted online with my other calculators with the help of CanadianCapitalist and FrugalTrader.) The math was a bit tricky but thank goodness it seems I figured out how to do it without resorting to Visual Basic.

My figures won't match yours because I am not taking the year's income on the first day of the month but rather taking it on a monthly basis which allows the portfolio to last longer (or provide more income).

With the following:

Investment Portfolio - $705,191
ACB - $326,565
Number of years - 25
MTR - 25%
Growth Rate 8%
Inflation Rate - 2.5%

I calculate $47,882 in after tax income for the first year and then adjusted for inflation accordingly.

Correspondingly, it would require an RRSP portfolio to start with $751,850 in order to provide the same after tax income. Which is a little less than the $755k in your original example. That supports your conclusion that higher MTR's provide more potential benefit for the leveraged meltdown.

Changing it to an MTR of 46.41% yields a $44,932 after tax income for the non-registered portfolio starting at $705,191 whereas the RRSP needs to begin at $803,880 to provide that kind of income.


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## steve41 (Apr 18, 2009)

I have to warn you... you are going to be approximating income tax in a calculation in which tax is an extremely sensitive component. Remember, there is no such thing as a marginal tax rate nor an average tax rate... there is only the T1 itself... an algorithm with multiple rates and thresholds (indexed to inflation), clawbacks, age credits, interest and dividend credits and with both a federal and provincial component.

To attempt an after-tax, inflation adjusted, tax-accurate model with a spreadsheet will get you nowhere. It is a hugely complicated 'needs-driven' number crunch using nested recursion. I wouldn't even bother... you will go nuts.

Think of it this way... the income tax rules have been with us for many decades, and the laws of compound interest for a century or so. In all the years that spreadsheets have been with us, wouldn't it seem reasonable that someone would have done this already?


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## cannon_fodder (Apr 3, 2009)

steve41 said:


> I have to warn you... you are going to be approximating income tax in a calculation in which tax is an extremely sensitive component. Remember, there is no such thing as a marginal tax rate nor an average tax rate... there is only the T1 itself... an algorithm with multiple rates and thresholds (indexed to inflation), clawbacks, age credits, interest and dividend credits and with both a federal and provincial component.
> 
> To attempt an after-tax, inflation adjusted, tax-accurate model with a spreadsheet will get you nowhere. It is a hugely complicated 'needs-driven' number crunch using nested recursion. I wouldn't even bother... you will go nuts.
> 
> Think of it this way... the income tax rules have been with us for many decades, and the laws of compound interest for a century or so. In all the years that spreadsheets have been with us, wouldn't it seem reasonable that someone would have done this already?


Steve,

Wouldn't it seem logical to conclude that if someone is predicting what will happen 10-35 years out with things like potential investment growth, marginal tax rates, inflation, etc. that they are aware there is very little likelihood the end result will match the prediction?

Thus, any attempt at predicting the future will be fundamentally flawed especially with so many variables. Yet, many of us still do it! It is a forecast - the word which originates from "fore" (something you say when your attempt to meet your goal misses the target badly) and "cast" (something you need to help mend your broken bones which were caused by blind self-belief). 

I'd argue that the growth rate and inflation rate are actually bigger factors as opposed to the tax rate in determining the outcome. Even if you took all of your money tax free vs. at 50% taxed, the impact to your income is smaller than a portfolio that grows at 4% vs 8% or inflation that is at 1% vs 4%.


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## steve41 (Apr 18, 2009)

All true. However, if you are trying to determine options such as "do I choose the TFSA, RRSP, both?", "pay off my loan or invest in my RRSP?", "choose early or late CPP?", etc, it is desirable that the tool you use is as accurate as possible. You can always vary (hi/lo/med) the rates, or montecarlo, but the more inclusive and in-depth the underlying logic, the more believable the results.

In a client-advisor setting, the advisor will be less credible in the client's eyes if taxation is glossed over, IMHO. (and heaven knows advisor credibility is a scarce commodity these days)


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