Published October 7th, 2017
This is a guest contribution from Charles Fournier who runs the Financial Freedom is a Journey blog.
Charles retired in his mid 50s in May 2016 from a career in Canadian banking. He relies exclusively on income from rental properties and a dividend income stream from a portfolio he amassed over several years. A portion of his typically relaxing week is used to share his knowledge with others through his website. Charles is clearly aware he learns from other investors, and therefore, welcomes feedback.
Recently I discussed my wife’s and my journey to financial freedom. I explained that we had diligently saved and invested in an effort to step away from the “rat race” earlier than most people.
In my recent Brookfield Asset Management – Calling All Long Term Investors post, however, I expressed concern about having accumulated too much money in tax advantaged accounts.
I have also had recent conversations with retirees on this subject matter and provide their opinions
“When I stopped working I had half my money in a non-registered account and half in RRSP including a Locked-In RSP. This was 1999. In the early part of the 2000’s I tried to run down my RRSP and Locked-In RSP. I was unsuccessful. When I was sold on RRSPs it was on the basis that I would get a tax refund for any money put into an RRSP and that when I would start to take money out I would be in a lower tax bracket. Never worked that way. I ended up putting money into an RRSP at a lower tax bracket than when I am taking it out.”
– Susan B., Toronto, Ontario, Canada
“My father, who is 92 and has RRIFs currently in excess of $700K, thinks they are a ‘jack-ass’ stupid idea.”
– Peter K., Toronto, Ontario, Canada
I have also received feedback on this subject matter from my father-in-law. He uses slightly more colorful language when he describes his tax predicament; it would be inappropriate for me to quote him verbatim in this post.
Given the above, I thought I would write this post to:
- Warn you that the nature of the accounts in which you save and invest could have significant negative tax implications;
- Provide a suggestion to avoid the predicament you may face if you follow the popular convention that you should continually maximize your contributions to tax advantaged accounts.
My wife and I are Canadian residents. In Canada we have what is known as Registered Retirement Savings Plans (RRSP). If you do not reside in Canada I strongly suspect the country in which you reside has a similar offering.
Over the course of our working careers, we were guided by recommendations from The Canadian Federal Government and the Canadian financial institutions that we diligently maximize our RRSP contributions for the purpose of creating a “nest egg” to fund our retirement.
Each year we maximized our contributions, invested properly, and received our tax deductions. At no point in time did ANY party indicate that having too much money in RRSPs can be detrimental.
In 2015 my wife retired at the age of 52. I retired in 2016 at the age of 56. When I retired in 2016 we had a financial advisor review our financial situation. What was pointed out in this review was that we had accumulated too much money in our RRSPs. We had essentially put ourselves in a position where unless we commenced a Retirement Account Meltdown Strategy, our retirement years were those in which we would incur the highest tax burden during our lifetime.
Coincidentally, the day I composed this post, the following article appeared in the financial section of the Financial Post. Here is a couple with a modest income and a modest amount in RRSPs and the guest financial advisor is recommending a Retirement Account Meltdown Strategy!
I recognize some readers may be unfamiliar with RRSPs offered in Canada. I, therefore, recommend you click on the links within this section of the post so you can quickly familiarize yourself with them. This will allow you to ascertain what is a comparable offering in your country.
The Canadian Federal government allows taxpayers to contribute annually a predefined percentage (up to a maximum) of employment income toward a RRSP. Contributions are made with after-tax dollars and the contributions are treated as a tax deduction. Here is a Tax Planning Guide that provides more detail.
Funds in the RRSP can be invested in a host of permissible instruments. No taxes are paid on the growth of, or income from, the assets held within the RRSP. Tax is only payable when withdrawals are made from the RRSP.
While the ability to grow your assets on a tax free basis is certainly attractive, there is no such thing as a “free lunch”. It is entirely possible that you could amass an amount in your RRSPs where when it comes time to convert your RRSPs to Registered Retirement Savings Accounts (RRIFs), you are in a position where your mandatory RRIF withdrawals place you in the highest 2017 Federal and Provincial income tax brackets.
In an effort to minimize taxes, some individuals may invest in schemes that promise tax free withdrawals from RRSPs and RRIFs. Canada Revenue Agency, however, has warned that investing in such schemes could result in the entire loss of your retirement savings to unscrupulous promoters, as well as a reassessment of your tax returns.
Retirement Account Meltdown Strategy Prior to RRIF Conversion
In this section, I disclose the tax implications if:
- Each member of as couple has $2,000,000 in their respective RRIF
- The couple are 72 and 75 years of age
- The couple resides in the province of Ontario in Canada.
This table outlines the minimum RRIF annual withdrawal limits.
The party who is 72 will need to withdraw $108,000 (5.4%) while the party who is 75 will need to withdraw $116,400 (5.82%).
This couple’s equity portfolio generates dividend income equivalent to, or greater than, the mandatory RRIF withdrawal limits. The balances in the RRIFs could continue to increase because the investments are appreciating in value and the dividend income is offsetting the vast majority of the RRIF withdrawals.
Fast forward 10 years to ages 82 and 85. This couple’s investments continue to perform well, the RRIFs are greater in value than at the time of retirement (say $2,200,000), and the payout percentages are higher (7.38% and 8.51%). This couple now has to withdraw $162,360 and $187,220 on which Federal and Provincial taxes are owed; here are the 2017 Federal and Provincial income tax tables.
In addition to this couple’s RRIF income, this couple is eligible to collect Canada Pension Plan (CPP) and Old Age Security (OAS). Unless this couple implements a Retirement Account Meltdown Strategy, the OAS payments will very likely be fully “clawed back”.
In our case, our detailed financial plan clearly indicated we needed to commence a retirement account meltdown strategy well before we converted them to RRIFs. Our game plan is now to withdraw more than what is required to sustain our lifestyle.
We will incur tax in the year of the withdrawals but whatever does not go toward taxes or living expenses will be reinvested in blue-chip equities in our non-registered investment accounts. Since we are already withdrawing funds from our RRSPs that exceed our living expenses, there will be no need for us to liquidate the investments in our non-registered accounts to sustain our lifestyle.
At age 71 we will convert our RRSPs to RRIFs. The RRIF balances will have been reduced over the course of several years thus resulting in significantly lower mandatory annual withdrawals at lower tax rates.
In addition to our RRIF withdrawals, we will collect dividend income, CPP, and OAS; it is possible our income will be low enough that we will be able to retain a significant proportion of the OAS payments (reduce or eliminate the “claw back”).
We typically buy and hold blue chip equities so we will pay no tax on any capital appreciation for many years; we will merely incur a tax liability on the annual dividend income. As you can see from the following table, the marginal tax rates on eligible and non-eligible dividend income is less than that on other income (RRSP and RRIF withdrawals fall under other income).
We currently collect rental income but I suspect we will sell the rental properties before we attain the age of 71; the proceeds from the sale of the rental properties will be invested in blue chip equities in non-registered accounts thus generating additional dividend income. The equities purchased with the proceeds from the sale of the rental properties will also remain untouched so there will be no tax incurred on the capital appreciation.
In addition to investing in non-registered accounts, a portion of the annual retirement account meltdown withdrawals we do not require for living expenses, will be plowed into our Tax Free Savings Account (TFSA) accounts. The current maximum annual contribution limit is $5,500/person.
Retirement Account Meltdown Strategy Employing the Use of Leverage
Some readers may contemplate the use of leverage to assist with the meltdown strategy. This entails the use of “investment” loans, possibly for the purpose of investing in blue chip equities in non-registered accounts. The interest on these loans is serviced from RRSP withdrawals. The RRSPs withdrawals are taken into income but loan interest is tax deductible.
In theory this strategy is appealing. In my opinion, however, there are several factors that can turn what is appealing into something that is far less than desirable. I don’t even need to crunch any numbers.
I recognize you may have a different tolerance for risk than me but why would you employ a strategy where the liability is a certainty but the upside is an unknown?
These are the potential risks I see.
- Lose money in the latter stages of your life and the ability to recover is generally more challenging than if it occurs earlier in life. Say you’ve been retired for a few years and you quite enjoy no longer having to put up with the daily grind of commuting to work. If your leveraged investment strategy really turned ugly and you had to resort to working again, would your stress level rise?
- In Canada, the Prime rate at the major Canadian financial institutions is currently 3.20%; financial institutions set their own prime rates based on the cost of short-term funds and on competitive pressures. The Bank of Canada influences the cost of short-term funds by setting the target for the overnight rate.
Chances are you will have to pay a spread above your bank’s Prime rate but for the purposes of this example let’s suppose you negotiate Prime + 0% and you borrow $200,000. Your interest obligation of $6,400/year, or $533.33/month, is tax deductible but you still need to come up with this money monthly regardless of how your investments perform.
- Depending on your circumstances you may be able to borrow dollar for dollar. This, however, is typically not the case. The lender wants a margin of safety so it might require additional security. If you are not willing to pledge $2 of equities for every $1 borrowed, you may need to pledge security such as a continuing collateral mortgage against your principal residence. You open to that idea?
- What if we experienced a major market correction and the value of your investments securing your investment loan dropped to the stage where a margin call was triggered? You would need to come up with additional security to avoid the “fire sale” of your investments by the lender.
- If you are acquiring investments in a currency other than the currency of your country of residence, you are exposing yourself to foreign exchange risks (eg. borrow in Canadian dollars to invest in US equities). You could borrow in US dollars to remove the foreign exchange risk but then you need to ensure you have sufficient US income to service the US debt.
- What if the Federal government decides to change the tax rates on different forms of income?
- Many readers of this post have a spouse/partner whose tolerance for risk is entirely different. I can’t speak for you but if I were to employ leverage and things were to turn ugly, I wouldn’t want to break the unpleasant news to my wife.
- If something were to happen to you where you no longer have the capacity to oversee the leverage strategy, who would take over from you? I know my wife has no interest in this stuff and would be completely stressed out if there were any debt.
- We currently have life insurance. The death benefits would wipe out the loan obligations but what if I don’t pass away and am in no condition to manage our affairs (long-term disability insurance would be far too costly)?
I recognize there are advantages to employing leverage but this strategy is not suitable for everyone. If you decide you want to employ leverage please ensure you go in with “eyes wide open”.
- Perform a sensitivity analysis to see what would happen if certain negative events were to occur;
- Determine how you would “rectify” the situation if things went off the rails.
Fortunately we are in a situation where we have several years over which we can employ our Retirement Account Meltdown Strategy. I suspect, however, that some of you are in a predicament where:
- You have accumulated significant amounts in your retirement accounts;
- Have retired shortly before you must commence mandatory withdrawals from your retirement accounts.
If this is your predicament, I feel for you. If, however, you have several years before retirement then you have a chance to reassess whether continuing to maximize contributions to tax advantaged accounts is really your wisest strategy.
I sincerely hope this post has been enlightening and thought provoking. If this is the case, I invite you to follow me at Financial Freedom is a Journey!