Converting Your RRSP to a RRIF

While most Canadians in the saving stage of their lives are happily contributing to and saving money on taxes with the RRSP (Registered Retirement Savings Plan), their older contemporaries are dreading the RRSPs close cousin, the RRIF (Registered Retirement Income Fund).

The RRSP is a fantastic savings plan that is nearly always the best account to prioritize when saving for retirement. When you contribute to your RRSP, you get to deduct the exact amount of your contribution from your annual income at tax time. This means you are effectively contributing to your RRSP with "before-tax" money. Contributing with before-tax money helps you maximize your savings and minimize your tax bill.

However, the RRSP has a few catches. Withdrawals from your RRSP are fully taxable as regular income. Also, you are subject to tax withholding on RRSP withdrawals. For example, if you want to withdraw $20,000 from your RRSP, the bank will withdraw an extra $8,571 and send that money straight to the Feds for a total withdrawal of $28,571.

When you do your income tax filing, months later, that $8,571 will show as taxes already paid. Your total RRSP withdrawal (taxable income) will show as $28,571. Then, if the bank withheld too much money from your RRSP as part of the mandatory tax withholding, you get a tax refund bank for that same amount. If you should owe no tax at all based on your income and deductions, the CRA will send the entire $8,571 back to you.

This hefty tax withholding is not an accident. While the government wants you to save in your RRSP, they also want to discourage you from withdrawing money from your RRSP until you are retired. While the benefits of discouraging early RRSP withdrawals probably outweigh the costs overall, it is certainly inconvenient for a high saver, early retiree.

The account the government wants you to withdraw from is the close cousin of the RRSP--the RRIF.

An Overview of RRIFs

The RRIF is the withdrawal-only version of the RRSP. You cannot contribute to a RRIF and you must make minimum withdrawals every year based on your account valuation and age on December 31 of the previous year. It is important to note that you can use the age of the younger spouse when calculating your RRIF factor minimum withdrawal.

In your RRIF, you may invest the money in the exact same instruments as a RRSP. This also includes holding your own non arms length mortgage. When moving money from your RRSP to your RRIF, you should be able to transfer those investments over "in-kind". Also, the transfer and any asset sales within your RRSP or RRIF account are not considered taxable events.

To calculate the minimum amount of your withdrawal, use your age on December 31 of last year, find your RRIF factor, and multiply that by your RRIF account value on December 31 of last year. For example, if my 65th birthday is in February of the current year and my RRIF account valuation on December 31 of last year was $300,000, my minimum withdrawal for this year is $11,539 ($300,000 * 3.8462%). I must withdraw at least $11,539 sometime between January and the end of December of the current year.

This is the minimum withdrawal factor table from age 50:

Source: TheRichMoose

Every RRSP account must be converted to a RRIF account in the year that the account holder turns 71. However, anyone holding an RRSP account may convert a part, or all, of their RRSPs to a RRIF at any age.

Benefits of Withdrawing from a RRIF

There are a few reasons why someone under the age of 71 would voluntarily want to convert their RRSP to a RRIF. Even in these circumstances, I believe it is generally best to convert just part of your RRSP to a RRIF to take advantage of the benefits. Leave an active RRSP account in place so you have the option of contributing and getting tax breaks should your circumstances change.

1. Take advantage of pension income tax credit

If you are 65 or older, you are eligible to claim the pension income tax credit for certain forms of income. Pension income includes RRIF withdrawals, but does not include standard RRSP withdrawals.

The pension income tax credit will give you a $2,000 deduction at tax time, helping you save hundreds of dollars a year in tax. The exact amount will depend on your income and province of residence.

If this is your goal, you should be careful only to transfer enough money to your RRIF from your RRSP to take advantage of this credit.

2. Splitting income with your spouse

If you are over the age of 65, and you are eligible for the pension income tax credit, you can also split up to 50% of your qualified pension income (includes RRIF withdrawals) with your spouse. Splitting income with a spouse is a huge tax benefit that can cut your tax bill in half.

For example, if you spend $50,000 per year in Ontario, you would have to withdraw $56,500 as an individual, but that drops to just $53,200 if it is evenly split with your spouse. Never say "No" to saving an easy $3,300 per year on taxes alone.

If you have a large RRSP, but your spouse does not, then moving a substantial portion of your RRSP to a RRIF at age 65 could be well worth your while just to take advantage of income splitting and saving money on tax.

3. Save money on withdrawal fees

Most brokerages will charge a higher fee for RRSP withdrawals than they do for RRIF withdrawals. This is because RRSP withdrawals are considered a partial de-registration. The brokerage fee for a RRSP withdrawal will probably be in the range of $50. A withdrawal from a RRIF can be anywhere from free to $50 at most brokerages.

If you are only doing one withdrawal per year, which I recommend if you are doing a RRSP withdrawal for the tax free RRSP withdrawal plan, switching to a RRIF to save fees probably isn't worthwhile. But, if you are looking for steady monthly income by way of registered plan withdrawals, it is almost certainly better to move at least a good portion of your RRSP to a RRIF.

4. Avoiding income tax withholding

When you withdraw money from a RRSP account, the brokerage is obligated to withhold anywhere from 10% to 30% of the value of the withdrawal and remit that to the CRA as an advance on your income tax bill for the year. However, up to the minimum withdrawal amount based on your RRIF factor, your brokerage will not withhold any money for taxes on RRIF withdrawals.

If you know you are withdrawing a certain amount of money from your RRIF every year, it may be worthwhile to convert some of your RRSP to a RRIF. I should point out that the argument here is weak because you will get any excess taxes withheld from you refunded back in March or April when you do your taxes.

The income tax withheld on RRSP withdrawals is not a separate tax from income tax itself, it is simply an advance to the CRA to discourage you from making withdrawals from your RRSP, and ensure the government gets paid their due. It is no different from your employer withholding tax from your paycheque or the CRA requiring you to make installment tax payments throughout the year if you are self-employed.

Summary

In general, I believe it can be advantageous from a tax savings and fee savings perspective to convert part of your RRSP to a RRIF when you turn 65 and are otherwise eligible for the pension income tax credit. Be hesitant to convert your entire RRSP over to a RRIF before the age of 71. Doing so will limit your options to contribute to a tax advantaged account and reduces withdrawal flexibility.

You can move money from your RRSP to a RRIF in chunks every year, so it is often worth your while to do some math and find an optimal RRIF balance to maintain for your personal situation. When in doubt, err on the side of caution and keep your RRIF a bit smaller than your calculations would suggest the maximum amount should be.

You are not required to open your RRIF at the same brokerage where your current RRSP is held. Examine your options and look at the fees for each brokerage. While some online self-directed brokerages charge annual fees and withdrawal fees for RRIF account, others do not. Look for low cost options and save yourself hundreds of dollars in fees each year.

Once you have opened a RRIF, think about your overall withdrawal plan and your investment situation. To keep your finances easy to manage, it may be a good time to open a high interest savings account. Consider making withdrawals from your RRIF just once or twice each year and depositing that money in the savings account.

Make your minimum withdrawal amount based on your RRIF factor at the beginning of each year as no tax withholding is kept from this withdrawal. Make any additional withdrawals near the end of the year to reduce the amount of time the CRA is holding onto your money. Don't forget you may be realizing taxable income from other sources (dividends or interest from non-registered investment accounts, rental properties, CPP/OAS, etc.) throughout the year.

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Tax Free RRSP Withdrawal Plan

The Tax Free RRSP Withdrawal Plan is an elaborate strategy that you can use to get a large amount of money out of your RRSP and pay little to no tax on those withdrawals. Using a RRSP self mortgage, also known as a non arms length mortgage, you can get money out of your RRSP in the form of a loan. This is a common strategy. However, the problem is that loans must be paid back, even if it's to your RRSP. This plan will take advantage of certain tax rules to pay the loan back but withdraw most of that money again tax free.

By conventional tax planning, there are few legal methods of withdrawing RRSP money effectively tax free on a small scale: withdrawing money to the basic personal deduction amounts, splitting withdrawals with your spouse, offsetting with some Canadian dividend income, and so on.

This strategy detailed in this post, the Tax Free RRSP Withdrawal Plan, might be the only legal way to get significant amounts of money out of your RRSP tax free, or with very substantial tax savings. I don't believe this strategy is very common at all, even in professional financial planning circles, as I cannot find details about this strategy specifically anywhere online.

I am using the best information I have to ensure this strategy complies with the CRA's tax rules and folios concerning RRSP qualified investments and investment loans, but tax law and the tax acts are complicated and you should verify the rules with a professional accountant before you implement this strategy yourself.

In this post, I will elaborate and provide an example scenario so you can see how it works. But first, lets briefly go over RRSP self mortgages.

Overview of RRSP Self Mortgages

When I'm talking about a RRSP self mortgage, I mean a non arms length mortgage against your own home that is provided by available funds in your RRSP/RRIF/LIF/LIRA/L-RSP/RDSP account.

To have your personal RRSP account loan you money secured against real estate, the CRA established several rules to prevent abuse of the process and to ensure your RRSP amount (where all the contributions were made with tax-free money) is protected in all scenarios.

  • You must have a self-directed registered account with an approved trustee. Trustee's I could find include Canadian Western Trust, TD Bank, CIBC Bank, and B2B Trustco.
  • The mortgage loan must be secured against a house that is your primary dwelling, or a vacation home.
  • If the property has multiple self-contained units, it cannot have more than 4 units and one of those units must be occupied by you.
  • The loan value cannot exceed 90% of the independently appraised property value which must be less than $1,000,000.
  • The mortgage loan must be insured by CMHC or Genworth Financial, regardless of the loan-to-value ratio or your other assets.
  • You must have the cash available in your self directed RRSP to fund the entire mortgage amount including set up fees.
  • You are required to have an appropriate downpayment, or equity in your home, that's separate from your desired RRSP self mortgage amount.
  • You must provide all necessary paperwork and meet the criteria to obtain a mortgage as if it were from a commercial bank.
  • The mortgage loan must be set at terms and an interest rate which is consistent with commercial practices.
  • You must make regular mortgage payments to your RRSP, or your trustee is required to foreclose on you just like any bank would.

You can find out more details of self directed RRSP non arms length mortgages by reading my first post on the subject.

The Tax Free RRSP Withdrawal Plan

I believe the Tax Free RRSP Withdrawal Plan is most suitable for an individual or couple that meets certain criteria: they own their own home and it is currently mortgage free; they have a large RRSP account that is self-directed, or could be; and, they are in a stage of life where they are withdrawing money from savings, not contributing to savings.

Normally, if you make withdrawals from your RRSP, RRIF, etc., those withdrawals are classified as regular income. That means you must pay full tax rates on those withdrawals. It is basically the same tax-wise to earn $60,000 a year at work as it is to withdraw $60,000 a year from your RRSP.

The hefty taxation on RRSP withdrawals relative to other forms of income can significantly limit the true value of your RRSP. If you have an RRSP worth $1,000,000 and are withdrawing $60,000 a year as a single person, your tax rate on that withdrawal will be around 20% depending on your province, leaving you about $48,000 in spending money. That means your $1,000,000 RRSP actually has a net value of $800,000 after adjusting for those deferred taxes.

In comparison, for that same $60,000 of income via Canadian dividends or asset sales (after adjusting for purchase costs) in a non-registered account the tax rate will be approximately 5%.

Due to the massive difference in tax rates between account types, there is a significant tax advantage if an investor can get money out of their RRSP and into a non-registered account. The problem is tax rules don't allow a straightforward switch like that. As stated earlier, it is nearly impossible to legally get money out of your RRSP tax free.

However, that all changes with this strategy. It is also why the Tax Free RRSP Withdrawal Plan takes a bit of leg work to set up. But once it is in effect, it is actually quite easy to maintain.

As far as I can tell, it meets all the tax rules in place, including directives in the CRA's income tax folios.

CRA RRSP Qualified Investments: See Sections 1.32 & 1.36

CRA RRSP Prohibited Investments: See Section 2.18

CRA Interest Deductibility: See Sections 1.25-1.27, 1.35-1.37, 1.41, 1.69

1. Set up a RRSP self mortgage with a trustee

The first step is to set up a RRSP self mortgage against your own home. Using your RRSP, you can obtain a mortgage loan against your home up to 90% of your home's appraised value; however, consider going up to 65% of your home's value to reduce mortgage insurance fees.

Once all the paperwork is done, your trustee is in place, and your mortgage terms are established, your RRSP account will write you a check for the full value of the loan amount.

Since the RRSP is making a "qualified investment" (as per CRA rules) by issuing a mortgage loan to you, the money from your RRSP is issued to you 100% tax free. It is not considered to be a RRSP withdrawal.

For the purposes of this strategy, you want to set the interest rates as high as legally possible. This would often be a 10 year fixed rate mortgage from a big bank.

2. Open a self-directed non registered investment account

Next, you will set up a new non registered investment account, generally with a online brokerage. You will deposit the entire check into this investment account ensuring there is a clear paper trail from your RRSP loan to this account. Do not use the money for any other purpose.

It is important to have a nice, clean paper trail to ensure there are no questions raised down the road regarding what the RRSP self mortgage money was used for. This is why I recommend a new non registered investment account that is solely used to facilitate this strategy.

3. Invest in assets which pay eligible income

Within your new non registered investment account, you must use all of the loan money to purchase investment assets which generate income. For the purposes of this use, the CRA's tax folios explicitly state income includes dividends from corporations (would also include ETFs) as well as investments in interest paying bonds.

For tax efficiency reasons, I recommend buying Canadian corporations which pay a moderate dividend yield, or ETFs which hold publicly traded stocks which in aggregate pay a small dividend yield. Do not buy ETFs which hold high yield foreign stocks or high yield bond interest income.

There is no requirement that the income from your investments exceeds the interest paid for your loan. But be careful that you are not required to sell assets from your non registered investment account which exceeds the principal repayment amount for the year (as a percentage of the original loan). This may render part of your RRSP self mortgage to be not tax deductible.

4. Keep track of the interest paid on your RRSP self mortgage

Each month, you must make mortgage payments towards your RRSP, just as you would make regular mortgage payments to a commercial bank. You need to keep track of the interest portion of your mortgage payments throughout the year.

Since the RRSP self mortgage is an amortized loan, the interest paid each year will slowly decline over time as the principal of the loan is repaid and the loan amount shrinks. This actually shrinks the size of your tax deduction over time as well. (Disappearing source rules.)

5. Withdraw an amount from your RRSP equal to or greater than your interest deduction

At the end of each year, once you have confirmed the precise amount of interest you paid on your mortgage loan and any other tax deductions you may have, you will withdraw the maximum amount of money you can from your RRSP account while ensuring you are below the amount where you will begin to pay income tax.

Remember, if you are withdrawing from an RRSP (not RRIF or similar), you will be subject to a tax withholding that can be credited back to you at tax time depending on your overall income tax owing.

This money can be used as spending money, to pay the RRSP mortgage payments, to invest in your TFSA or a separate non registered investment account, or any other purpose you wish.

For easy tracking purposes and clarity of source, if you have enough extra money left for investing in a non registered account make sure you open a new account for these additional deposits.

6. Make the appropriate tax deductions

While the RRSP withdrawals will be considered fully taxable income, the interest expense will be fully tax deductible, effectively making the RRSP withdrawal a tax free withdrawal.

You may also deduct all the costs of administering and setting up your RRSP self mortgage from your income at tax time. This means the first year when you set up this strategy you will have a tax deduction of thousands of dollars just in fees.

7. Consider refinancing the RRSP self mortgage once it makes financial sense

At some point down the road, you may want to refinance your RRSP self mortgage and increase the loan amount. That is provided you have the available cash in your RRSP and your home equity amount will be sufficient to meet the standard self mortgage requirements.

Always make sure the tax savings from the refinancing will outweigh the costs of setting up a new RRSP self mortgage.

A refinancing even will reset the mortgage terms and once again increase the amount of interest expenses each year which you can deduct from your income at tax time. This will allow you to increase your tax free RRSP withdrawals each year.

Example: Big RRSP, Valuable Home

In this example we will show exactly how the Tax Free RRSP Withdrawal Plan can work in one of the most ideal situations.

Paul, a retired man, owns a $1 million home with no mortgage and has a $1 million RRSP. We'll assume Paul lives in Ontario and requires $50,000 in spending money each year (after taxes). He does not yet receive CPP or OAS.

In a normal situation, assuming normal tax rates and no other income, Paul will need to withdraw $61,700 per year from his RRSP and be paying $11,700 per year in taxes (a blended tax rate of 18.96%).

To save on taxes, Paul sets up a Tax Free RRSP Withdrawal Plan by taking out a $650,000 mortgage against his house with a RRSP self mortgage. He chooses a loan-to-value ratio of 65% to save on mortgage insurance fees. The setup fees including mortgage insurance total $5,000. In this strategy, Paul wants to choose the highest interest rate he can. Currently, he can obtain a 10 year fixed mortgage for 6.6% from a big bank. At a 25 year amortization, he will be making monthly payments of $4,393 back to his RRSP.

He deposits the $650,000 loan amount into a new non registered investment account. This leaves $345,000 remaining in his RRSP account after setup fees.

Paul invests the $650,000 into a portfolio of Canadian stocks which yields 3% in eligible dividends and generates an annual capital return of 4%. For comparison's sake, we'll assume the RRSP also returns 7% per year.

While the size of the RRSP withdrawal can be whatever you like, to be the most tax efficient we'll say that Paul withdraws the entire value of the interest deduction each year from his RRSP plus any additional amount to maximize the withdrawal before taxes apply (not including the Ontario health tax). He then funds anything else required from the non registered account.

The mortgage payments and annual living expenses are covered from a combination of RRSP withdrawals (up to the tax free amount), dividends from the non registered account, and selling investments realizing some capital gains as needed.

This is the annual schedule of finances for the first 10 years (until the end of the first mortgage term):

Sources: TheRichMoose, TaxTips, RateSupermarket

Throughout this entire period, Paul only pays the Ontario Health Tax which is $450 per year at his income level. While the RRSP self mortgage cost him $5,000 in setup fees and mortgage insurance, that pays itself back in less than one year in tax savings alone. By the end of Year 10, Paul has saved himself $107,500 after costs with the Tax Free RRSP Withdrawal Plan.

Thanks to the tax savings ($11,250 per year), Paul's total cost of living is actually 20% lower than it would be with traditional RRSP withdrawals. This means his retirement savings will stretch further, reducing risk. Yes, he technically "spends" $103,170 each year after making those hefty mortgage payments, but all the money stays in his hands. He's not paying a bank, he's paying his RRSP.

It is important to note this plan does not materially change Paul's overall financial situation. He accumulated no new debt (which we'll define as money owed to another party), no greater assets (still has ~$1,000,000 in investments plus a paid off house), and no change in investment returns (still earns 7% per year on his net investment position). He simply loses $5,000 in one-time set up costs for this swap of assets while gaining $11,250 per year in saved taxes.

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