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.