The phenomenally dumb "RRSP meltdown"

People seem to love to throw away money just so they don't have to pay tax on it. Here's one of the dumbest tax-avoidance schemes I've ever seen: the "RRSP meltdown". I've heard of using leveraged investments to dodge taxes before (like the Smith manoeuvre), but none is more contrived and pointlessly risky.

"Leveraged investing" means borrowing money to invest, on the assumption that you'll earn more on your investment than you pay in interest. What seems to attract people to this idea is that you can deduct the interest from your taxes. This leads people to contemplate all kinds of wacko ideas, not the least of which is the RRSP meltdown.

How does the meltdown work? Let's suppose you have $100k in an RRSP and you don't like the idea of paying tax on it when you withdraw it. The RRSP meltdown works like this: say you borrow $150k from the bank. Let's say you pay $10k/year in interest. You then withdraw $10k/year from your RRSP. You're taxed on the withdrawal, but the interest is deductible, and so you break even! Sounds great, right?

But let's not forget that you're paying $10k/year in interest to the bank. If you have an interest-only loan, then after 10 years, when you're finished your meltdown, you've got no RRSP, you've paid $100k in interest, and you still owe the bank the original $150k principal!

After selling investments to pay back the bank, all you're left with is the earnings you got from those investments. And since you held that $150k outside your RRSP, those earnings are taxable! If you had just left your RRSP intact for those same 10 years, it would have compounded tax-free. You'd pay tax to withdraw it, but you'd still have at least half of it left over, no matter what tax bracket you're in.

Here's the dumbest part of all: what does the $150k loan have to do with your RRSP? Absolutely nothing. You can't use your RRSP as collateral for the loan. If the meltdown advocates were right, and it did make sense to borrow $150k to fund a leveraged investment, then why doesn't everyone do it, RRSP or not?

If your answer is "because they couldn't afford the interest payments", or "because leveraged investing is too risky", then you may be starting to see why this idea is so stupid.

Who wins with the new Tax-Free Savings Account?

The pundits are all over the new Tax-Free Savings Account (TFSA) introduced this week in the federal budget. They seem to want it to be complex and ambiguous, but it's actually pretty simple.

In an RRSP, you save your money, it grows tax-free, and then you withdraw it and pay all your taxes at the end. Who benefits from paying taxes at the end? Well, anyone who will be in a lower tax bracket when they withdraw the money than when they earned it.

In a TFSA, you pay tax on your money at the beginning, then you save it, and it grows tax-free from then on. Who benefits? Those who will be in a higher tax bracket when they withdraw the money.

Well, who in the world would be withdrawing their money at a higher tax bracket than when they earned it??

1. Twentysomethings living at home with a low-paying job and even lower expenses. By their mid-30s, they may be in a pretty high tax bracket, and now they can grow their savings tax-free and withdraw it tax free. For instance, their TFSA (which could be as much as $80k) can be plunked down as a downpayment on their first home with no repercussions whatsoever. That's four times as much as the RRSP home-buyer's plan limit, and without the forced repayments.


2. Low-income earners nearing retirement. Benefit "clawbacks" can put these people in a tax bracket of almost 90%, making an RRSP completely infeasible because they'd lose almost 90% of their savings. That means the lowest-income people are, ironically, the ones who can't make use of the tax-free compounding of RRSPs. The tax-free compounding of the TFSA puts these people on an even footing with richer Canadians.

In other words, the TFSA is encouraging two groups of people to save who ordinarily don't save very much. Sounds good to me.

Others probably won't benefit a whole lot from the TFSA. I guess people with too many investments to fit into their RRSPs—a very nice problem to have—can move some of the least tax-efficient ones (interest-earning investments like bank accounts and bonds) into the TFSA.