The idea of withdrawing funds from an RRSP tax free has appeal, but RRSP meltdown strategies can serve the interests of the brokerage industry more than those of investors

A loss in your RRSP deprives you of the opportunity for tax-free compounding that the money would have enjoyed within your RRSP tax shelters. That’s particularly costly. After as little as seven years in an RRSP, the ability of an RRSP contribution to grow and compound free of tax may be worth as much as your initial contribution itself.

The tax treatment of RRSPs is what sets them apart from other investment accounts. Below we share some information on RRSP meltdown strategies—one popular reason for withdrawing funds from an RRSP.

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RRSP meltdown strategy serve your broker’s interests

There are times when you may want to withdraw money from an RRSP. This has spawned one strategy, the RRSP meltdown, that can bring you more risk than reward.

Here’s how the RRSP meltdown works:

When you take money out of your RRSP, you have to pay tax on your withdrawal at the same rate as ordinary income in the year you make the withdrawal. However, under an RRSP meltdown strategy, you aim to offset the additional tax by taking out an investment loan and making the interest payments from funds you withdraw from your RRSP (the withdrawals must be equal to the interest payment).

Since the interest on the loan is tax deductible, the tax on the RRSP withdrawal is cancelled out. This, in theory, results in zero tax owing on your withdrawal. You can then use the investment loan to buy dividend-paying stocks, which you would use to provide income during retirement. Dividend-paying stocks also have the advantage of being very tax efficient.

The idea of withdrawing funds from an RRSP tax free has obvious appeal. However, we’ve looked at a number of different RRSP meltdown strategies over the years and, for the most part, we have found that they serve the interests of the brokerage industry more than those of investors.

Here’s why: Say you make a $5,000 annual withdrawal from your RRSP and want to offset your taxes payable using the interest from an investment loan. Supposing a 5% annual interest rate on the investment loan, you would have to borrow $100,000 to invest in dividend-paying stocks to generate a large enough interest deduction to offset the withdrawal.

The fees and commissions that the investor generates when he or she invests the money are an obvious benefit to the investor’s broker. The investor, meanwhile, significantly increases his or her leverage. Moreover, many investors attempt the RRSP meltdown when they’re at or near retirement. In other words, at the worst time to take on additional debt.

In general, though, borrowing to invest only makes sense if you are in the top income tax bracket, your income is secure, you have 10 or more years to retirement, you follow our low-risk investing approach, and you have the temperament to accept the wider fluctuations in net worth that you are sure to experience when you borrow to invest.

If you fit all these criteria, borrowing to invest makes sense for you.

But it doesn’t matter if you use your interest write-off to shelter income from employment, or income from RRSP withdrawals.

Let’s put it this way: Withdrawing money from your RRSP before you need to is one thing; borrowing to invest is a separate issue. You have nothing to gain by mingling the two, except confusion.

Use our three-part Successful Investor philosophy to build a lower-risk investment portfolio

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Have you made withdrawals for an RRSP using a meltdown strategy? How has it worked for you?