uses of technology: Timing RRSP withdrawals is important

Thursday, February 23, 2012

Timing RRSP withdrawals is important | Finance International

By Talbot Stevens

For all of the positives of RRSPs, there is one negative every RRSP investor will eventually have to deal with ? taxation. While some describe investment growth inside RRSPs as ?tax free,? I suggest ?tax deferred? is more accurate because eventually every penny of your RRSP (or RRIF) will be withdrawn as taxable income.

Recognizing that most Canadians prefer to pay less tax, the big RRSP question is: ?Are there ways to withdraw RRSPs tax free ? legally?? Yes, there are. Ignoring the Home Buyer?s Plan and Lifelong Learning Plan, which help fund your first home or an education, there are a few ways to pay less or no tax.

The first basic concept is to strategically time your withdrawals when your income is lowest. Since the basic personal exemption allows us to each earn about $ 10,000 a year tax free, if you had no other source of taxable income, you could withdraw this amount from an RRSP and effectively pay no tax. Your financial institution will withhold 10%-30% for taxes when you draw the money, but you should get this back when you file taxes if you have no other income.

Most of us can?t live on only $ 10,000 a year, but this idea can apply to more than hermits, especially now that we have TFSAs. If you retired a few years before your spouse, and they covered all of the expenses, you could draw the amount of the basic exemption each year from your RRSP tax free. Those who are single or not relying on the support of a partner could cover expenses by withdrawing from TFSAs or even unregistered equities that have capital losses. In both cases, there is no taxable income, so you can earn ? or withdraw from RRSPs ? the basic exemption without tax.

Even if you can?t withdraw your RRSPs tax free, timing your withdrawals to be taxed less might still be beneficial. If you could withdraw $ 30,000 a year in a 20% tax bracket early in your retirement, and were confident that your tax rate would jump to 35% or 45% later, it might make sense to take a smaller hit sooner, even though you give up years of tax-deferred growth.

The second fundamental way to reduce or eliminate tax on RRSPs is to create a tax deduction that offsets the tax on withdrawals.

A controversial approach that was popular in the past is the ?RRSP meltdown? strategy, where the offsetting tax deduction is created by the interest expense on an investment loan.

As an example, if you had $ 150,000 of RRSPs that was not critical to your retirement, you could withdraw, say, $ 10,000 a year over a 15-year period. Assuming a constant 5% cost of borrowing, $ 10,000 a year would cover the interest expense on a $ 200,000 investment loan. The tax due on the $ 10,000 RRSP withdrawal is offset by the $ 10,000 deduction for the interest expense, so you get your RRSP out ?tax free.? At the end of the 15 years you pay off the investment loan, essentially having converted your $ 150,000 of registered funds into hopefully a higher amount unregistered funds, which are taxed less as capital gains and dividends.

While an RRSP meltdown strategy can benefit the investor or beneficiaries on paper, it has many risks. Clearly, if you?ve never leveraged before, starting this riskier strategy when you?re near or in retirement, with funds that you can?t afford to lose, is a dangerous idea. Probably the biggest risk is related to timing and what?s called the sequence of returns. If you start the strategy just before a big market drop and your $ 150,000 quickly becomes $ 100,000, the $ 10,000 a year withdrawals will cause the RRSP to implode and not last 15 years. In addition, your $ 200,000 of leveraged investments will also be down a lot, resulting in significant losses and emotional stress.

- Talbot Stevens is a financial speaker and author of Financial Freedom Without Sacrifice.

From:Financial Post | Business ? Personal Finance