What is an RRSP Meltdown Strategy?

What’s the best way to pay the least amount of tax on your RRSP or RRIF accumulations?  “Average down” the taxes payable on your accumulated capital  by using the progressivity of the tax system (the more you make the more you pay) and the current tax brackets and rates to your advantage.

This is a wealth retention strategy that should be reviewed annually, particularly during the tax filing season.

Background – Federal Income Tax Brackets . To begin, find out what tax bracket your income is in and what  tax rates it will attract:

As you can see form the chart above,  for the 2016 tax year, income of $11,474 attracts zero income tax at a federal level.  Income from $11,474 up to $45,282 is taxed Federally at 15%, etc.

The Process.  You will want to “top up” your income enough to benefit from the lowest possible tax rate without slipping into the next bracket and a new, higher rate.

• Withdraw the funds to “top up to bracket”.  That is, withdraw enough to get to the top of at least the lowest tax bracket, bearing in mind any “clawback zones” that the client may pass through (ie.  OAS or refundable or non-refundable tax credits). 
• Remember, the financial institution will withhold a set % of income tax and remit this to the Government on your behalf, so take this into account in your cash flow planning.
• You will receive a T4RSP in February of the following year showing the amount withdrawn and the amount of income tax withheld from the withdrawal, which will then be reported on your personal income tax return.
• In a very simplistic example, assuming that you withdrew $10,000, and had no other income, $1,500 would have been withheld and this amount will be returned by way of a tax refund on filing of the T1 return.
• Wise investors would then reinvest the $8,500 and the subsequent $1,500 refund into a TFSA (assuming room availability) where the investment continues to accumulates tax free income until required in retirement.

Pitfalls.  Well yes, there are a few:

1. While no income tax is ultimately paid by the individual, if they are married or in a common-law situation, the claim for a spouse’s amount will be reduced dollar for dollar by the individual’s net income. 
2. If the RRSP funds were contributed by way of a spousal RRSP within the prior three years, the income will not be reported on the individual’s return but will revert back to be reported by the contributing spouses’ on his or her tax return.  This mechanism is in place to avoid manipulating income to achieve income splitting under the age of 65. 
3. If over the age of 65, pension income splitting may be possible.  Take this into account in  your meltdown strategies.
4. If the individual begins to earn employment income in the future, the contribution room that was used by the withdrawal is gone.  Additional contribution room would be required to make RRSP contributions in the future.   Remember there is an age limitation here – the end of the year in which the taxpayer turns 71.
5. Taxable withdrawals can attract the requirement to make quarterly instalment payments.

With thanks to Alan Rowell, MFA, DFA-Tax Services Specialist is a Master Instructor with Knowledge Bureau and Founder of The Accounting Place.

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