For some, RRSP freeze may be answer

By TIM CESTNICK
Globe and Mail, Jan 24

You've long heard the advice. You've even taken it to heart. I'm talking about maximiz ing contributions to your registered retirement savings plan.

But after so many years of hearing that maximizing RRSP contributions is critical to having enough in your retirement, it's time to ponder another possibility — that you may actually end up with too much in your RRSP. And if that's the case, you may want to consider the strategy of an RRSP freeze.

Don't get me wrong. There are still thousands of Canadians who have been neglecting the task of saving for retirement. Plowing as much as possible into that RRSP may still be an important step toward making ends meet once they're in their golden years.

The fact is, however, that there are a significant number of Canadians who have done a good job of socking away money in an RRSP. I've seen a growing number of people over the last couple of years who are on track to have too much in their plans by their retirement date.

Having enough in your RRSP to provide the income you'll need in retirement makes sense. Having more than you need in an RRSP does not.

Why not? Because the withdrawals that you make from an RRSP are not exactly tax-efficient. Every dollar withdrawn is fully taxable. By comparison, withdrawing cash from a non-registered investment account gives rise to tax-smart cash flow.

You probably know the rules: When you liquidate an investment outside of an RRSP, you'll pay tax on the growth of that investment only, not on the full proceeds of the sale. Further, that growth is not fully taxable; just one-half of any capital gains are subject to tax.

I'm not suggesting that you abandon your RRSP altogether in favour of investing outside your RRSP. I'm simply suggesting that it's possible to have too much in a registered plan.

Is there something that can be done if your RRSP has become a little too big? Sure there is. The strategy is called the RRSP freeze. It's not for everyone, but it can make sense in many situations. Take the example of Stan.

Stan is 50 years old, plans to retire at 65 and figures he'll live to 90. Stan wants an annual after-tax income from his RRSP of $50,000 in his retirement.

That's in today's dollars. The actual amount will be increased for inflation each year (which I've assumed to be 3 per cent). Stan's marginal tax rate is 46 per cent.

If you do the math, you'll find that Stan will need $1.7-million in his RRSP at 65 to provide that level of income for life. Today, Stan has an RRSP of $490,000. But assuming a 10-per-cent annual rate of return, his RRSP is on track to be worth $2.05-million by then — even if he doesn't make another contribution to the plan.

Did you catch that? Stan is on track to have about $350,000 more by 65 than he really needs to provide himself with the income he wants.

Maybe Stan should undertake an RRSP freeze. Here's how the strategy works: Stan could borrow $125,000 from the bank through an interest-only loan, then invest the money, which makes his interest costs deductible at tax-time.

With an 8-per-cent interest rate on the loan, he'll be on the line for annual interest payments of $10,000. Stan could pay the interest costs on the debt by making withdrawals from his RRSP in that amount each year.

Yes, the RRSP withdrawal will be taxable, but the taxable amount will be offset by the interest deduction of $10,000. That means the net impact on Stan's tax bill for the year will be nil.

Stan's withdrawals from the RRSP will slow down or "freeze" growth inside the RRSP to the point where his registered plan will now be on track to be worth the $1.7-million he needs at age 65.

In addition to the RRSP, Stan will also have a portfolio of investments growing outside the plan where the tax on liquidation will be tax-smart.

The bottom line: Stan's total retirement nest egg will be higher by a full $117,000 after taxes with this strategy than it would be simply by leaving he RRSP as is.

When I explain this concept to some people, they immediately ask: "What about RRSP contributions? In your example, Stan isn't making any RRSP contributions. Is he not giving up a valuable deduction here?"

The answer is a resounding no. That's because Stan is entitled to a deduction for the interest costs he's incurring on the investment loan. This effectively replaces the RRSP deduction. Stan could take $10,000 he might otherwise contribute to his RRSP and use the cash to pay the interest costs on a loan, entitling him to a deduction.

How do you know whether the RRSP freeze strategy is for you?

The first consideration is that you have to be a candidate to borrow money to invest.

Think about this one carefully because there are lots of issues to making that decision, including whether you can sleep easily at night when you owe money.

Still, the two most important criteria for being a borrower are these: You need to have stable and sufficient cash flow to meet the loan payments, and you should have a long-term time horizon (eight to 10 years or more) since "upvesting" (prudently borrowing to invest) is not a short-term strategy.

Using funds from your RRSP to finance loan payments can help take care of that "sufficient and stable cash flow" requirement.

Tim Cestnick is managing director, Tax Smart Services, at AIC Ltd. and author of Winning the Tax Game 2002.