RRSP Meltdown
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RRSP Meltdown
SCENARIO
The ideal situation is where you have an RRSP built up to say $50,000. So if you left this alone you would earn 8% per year (assumed rate for example purposes). The problem with your RRSP is that you have to pay roughly 30% tax on any withdrawls (depending on your tax rate). This strategy attempts to avoid this.
METHOD
What you do is you go take out a line of credit for say $240,000 paying interest at 5%. This works out to roughly $1,000 per month. You take the full line of credit and deposit the loan directly in your investment account, and buy stocks. This allows you to deduct the interest on the loan (roughly 30% deduction on interest paid).
Then you withdraw enough from your RRSP to cover the interest payment ($1,000 per month). This will cause you to pay 30% tax on the withdrawl, but you will be using this withdrawl to pay the $1,000 interest on the loan which will give you a 30% deduction. The result is no tax effect.
So right now it doesn't sound that great. You are paying your entire RRSP as interest on a massive loan, which will eventually have to be paid back when the RRSP runs out.
The strategy is that you are using your RRSP to essentially rent $240,000 which you will then invest for however long there is a balance in your RRSP to pay the interest on the loan. When your RRSP runs dry, you repay the loan, and the 8% per year for 4 years (50,000 RRSP balance / 12,000 per year interest) earned on the $240,000 should result in roughly $80,000 in earnings. If you had left the original $50,000 in your RRSP earning 8% for 4 years, it would grow to roughly $66,000.
The calculations shown above were using simple interest calculations (not taking compounding into effect), but the real advantage here is taxes.
With $66,000 in your RRSP, you would eventually pay 30% of that in taxes as you withdraw. $66,000  30% = $46,200
With the $80,000 held outside of your RRSP, you would 15% in taxes (capital gains/dividend tax rates) as you withdraw. $80,000  15% = $68,000 (The withdrawls from your RRSP were offset by the deductible interest payments).
Therefore, you will come out much farther ahead using this strategy.
POTENTIAL ISSUES
Availability of credit: Who is able to borrow $240,000 outside of a mortgage? You could take a smaller line of credit for longer, which should have the same effect. The idea is not really to win on the compounding of the larger investment, but to get the money out of the RRSP with a lower tax rate.
Your earnings are not guaranteed: while earnings using this strategy are greatly multiplied, so are losses which could be financially ruinous if your investments are not very conservative.
The assumed rates of earnings (8%), and the assumed interest rate on the loan (5%) may be unrealistic
The tax rules approximately state that in order for the loan interest to be deductible, you must prove that you are using the loan for investing purposes, and that there must be a reasonable expectation that you will earn interest or dividends (not purely capital gains). No real problem here as you can argue that any stock has a reasonable expectation of paying capital gains at some point.
The ideal situation is where you have an RRSP built up to say $50,000. So if you left this alone you would earn 8% per year (assumed rate for example purposes). The problem with your RRSP is that you have to pay roughly 30% tax on any withdrawls (depending on your tax rate). This strategy attempts to avoid this.
METHOD
What you do is you go take out a line of credit for say $240,000 paying interest at 5%. This works out to roughly $1,000 per month. You take the full line of credit and deposit the loan directly in your investment account, and buy stocks. This allows you to deduct the interest on the loan (roughly 30% deduction on interest paid).
Then you withdraw enough from your RRSP to cover the interest payment ($1,000 per month). This will cause you to pay 30% tax on the withdrawl, but you will be using this withdrawl to pay the $1,000 interest on the loan which will give you a 30% deduction. The result is no tax effect.
So right now it doesn't sound that great. You are paying your entire RRSP as interest on a massive loan, which will eventually have to be paid back when the RRSP runs out.
The strategy is that you are using your RRSP to essentially rent $240,000 which you will then invest for however long there is a balance in your RRSP to pay the interest on the loan. When your RRSP runs dry, you repay the loan, and the 8% per year for 4 years (50,000 RRSP balance / 12,000 per year interest) earned on the $240,000 should result in roughly $80,000 in earnings. If you had left the original $50,000 in your RRSP earning 8% for 4 years, it would grow to roughly $66,000.
The calculations shown above were using simple interest calculations (not taking compounding into effect), but the real advantage here is taxes.
With $66,000 in your RRSP, you would eventually pay 30% of that in taxes as you withdraw. $66,000  30% = $46,200
With the $80,000 held outside of your RRSP, you would 15% in taxes (capital gains/dividend tax rates) as you withdraw. $80,000  15% = $68,000 (The withdrawls from your RRSP were offset by the deductible interest payments).
Therefore, you will come out much farther ahead using this strategy.
POTENTIAL ISSUES
Availability of credit: Who is able to borrow $240,000 outside of a mortgage? You could take a smaller line of credit for longer, which should have the same effect. The idea is not really to win on the compounding of the larger investment, but to get the money out of the RRSP with a lower tax rate.
Your earnings are not guaranteed: while earnings using this strategy are greatly multiplied, so are losses which could be financially ruinous if your investments are not very conservative.
The assumed rates of earnings (8%), and the assumed interest rate on the loan (5%) may be unrealistic
The tax rules approximately state that in order for the loan interest to be deductible, you must prove that you are using the loan for investing purposes, and that there must be a reasonable expectation that you will earn interest or dividends (not purely capital gains). No real problem here as you can argue that any stock has a reasonable expectation of paying capital gains at some point.
Max SDDL Insider
 Posts : 297
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Join date : 20100701
Re: RRSP Meltdown
have you done this? don't you need something large secure a loan like this, some kinda equity????
aaronrwatts Posts : 16
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Join date : 20100806
Re: RRSP Meltdown
Nope, never done it and probably never will. I prefer to avoid to RRSP and leverage altogether for reasons discussed somewhere else. Still, it is an interesting strategy. Ideally you are performing the withdrawls in retirement, so the idea is that the massive loan is secured by you fully paid off house.
The risks of this strategy (relying on a consistently high rate of return, and huge leverage) can outweigh the benefits in many cases. It will be more worthwhile at larger dollar amounts, but this dramatically increases the size of the loan required.
The risks of this strategy (relying on a consistently high rate of return, and huge leverage) can outweigh the benefits in many cases. It will be more worthwhile at larger dollar amounts, but this dramatically increases the size of the loan required.
Max SDDL Insider
 Posts : 297
Reputation : 7
Join date : 20100701
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