May 25, 2007, 2:29 am

RIF Meltdown Strategy: A complete example

by: The Financial Blogger    Category: Leveraging Strategies
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First things first, I would like to thank Canadian Capitalist for hosting The Canadian Tour of Personal Financial Blog #3 earlier this week. This was definitely a great experience. For the tour, I posted an article about The RIF Meltdown Strategy explaining how to withdraw money from your RRSP without getting whipped by the taxes at the end of the year.

I received comments and emails about how profitable this technique could be for senior citizens who are not planning on investing their money in high risk portfolios. I then decided to create an example with real figures.

Here are the key points: You have 100K in RRSP and you would like to withdraw 7K for every year. You invested this money in a more conservative portfolio and your expected return is 5%. Your marginal tax rate is 35%. Therefore, you would pay $2,450 in taxes on a $7,000 withdrawal (7K*35%). After 10 years, you would have withdrew $70,000 and pay $24,500 in taxes. So your net income after taxes would be $45,500. Not bad.

I received comments and emails about how profitable this technique could be for senior citizens who are not planning on investing their money in high risk portfolios. I then decided to create an example with real figures.

Here are the key points: You have 100K in RRSP and you would like to withdraw 7K for every year. You invested this money in a more conservative portfolio and your expected return is 5%. Your marginal tax rate is 35%. Therefore, you would pay $2,450 in taxes on a $7,000 withdrawal (7K*35%). After 10 years, you would have withdrew $70,000 and pay $24,500 in taxes. So your net income after taxes would be $45,500. Not bad.

Now, take a 100K investment loan with an interest rate of 7% (right now, you can get 6% with most institutions) and pay interest only. Your 100K RRSP is still invested at 5% and you are withdrawing $7,000 again. At the end of the year, you will offset your 7K withdrawal with the 7K paid in interest on your investment loan. Then, what’s the point?

Year1

2

3

4

5

6

7

8

9

10

Invested Amount

$105,000

$110,250

$115,763

$121,551

$127,628

$134,010

$140,710

$147,746

$155,133

$162,889

Tax

$650

$683

$717

$752

$790

$830

$871

$915

$960

$ 1,008

RIF

$98,000

$95,900

$93,695

$91,380

$88,949

$86,396

$83,716

$80,902

$77,947

$74,844

Let’s suppose that you are investing at 5% as well. However, your return should be composed by dividend and capital gain instead of interest income. The main reason why is because dividend is taxed around 8% (please see your provincial laws as it vary from 4% to 17%) and your capital gain should be half of your marginal tax rate, so 17,5%. In order to produce the chart above, I calculated a 13% average marginal tax rate at the end of each year. I also took in consideration that you would sell all you investment and reinvest every year to crystallize gains and calibrate your portfolio. I know it would not happen in the real life, but it makes tax calculation much easier for this example.

As you can see, after 10 years, you would get more than 62K and pay a total of $8,176 in taxes for a net amount of $54,173 after taxes. Therefore, after 10 years, even with a very conservative portfolio, you would still make almost 10K out of this strategy.

If you are wealthy enough, or do not have an aversion to risk, you can invest at 8% without jeopardizing your retirement. If you keep your RIF at 5% but you change your investment loan return at 8%, here’s what you will get after 10 years.

 

Year

1

2

3

4

5

6

7

8

9

10

Invested Amount

$108,000

$116,640

$125,971

$136,049

$146,933

$158,687

$171,382

$185,093

$199,900

$215,892

Tax

$1,040

$1,123

$1,213

$1,310

$1,415

$1,528

$1,650

$1,782

$1,925

$2,079

RIF

$98,000

$95,900

$93,695

$91,380
$88,949

$86,396

$83,716

$80,902

$77,947

$74,844

 

You would then get 215K worth of investment with a 100K debt and you would have paid a total of 15K in taxes. After taxes, you would get 100K in your pocket so more than twice if you would just have withdrawn your investment.

 

I think the numbers speak for themselves. The real question is not really if the technique works or not but more if you are comfortable with leveraging strategies because there is always the risk of negative return. No pain, no gain!

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Comments

Very interesting strategy Mikael and the numbers do certainly speak for themselves. Am a bit young to enact this method of reducing taxes while whithdrawing money from RIF”s but i shall certainly print it out for future reference.

I have seen this strategy for a lot of people. I must admit I was quite surprised when I did the math at 5% and shown that it was still profitable. I guess I’ll have to wait another 30 years before trying it :).