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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Tax Time: Are You Getting a Big Refund?

It's that time of year again... tax time in Canada. This year every Canadian must file their 2017 taxes and pay any amounts owing by April 30, 2018. That's a little more than two weeks from today.

As most of you know, taxes in Canada are quite complicated. I always do my own tax returns using Genutax. There are other great software programs out there as well: Simpletax, Turbotax, and Studiotax for example. Doing your own taxes is a great way to understand how much tax you are paying and what you can do to reduce that amount as much as possible in the future. Trust me, the nice lady at the mall kiosk doesn't care.

Our tax system is a myriad of credits and deductions at both the federal and provincial levels. Child care, RRSP contributions, medical expenses, education, charitable contributions, union dues, interest costs, pension adjustments, kids fitness, arts, and whatever your government decides is good for you at that moment in time.

After you plunk all those numbers in your tax return, you find out if you get a refund from the government or if you owe them more money than what you already paid. What is the best outcome?

Getting a Nice Refund

Most people are very happy when they get a refund cheque sometime in April or May. However nice this little bonus might seem, it is NOT the ideal outcome. Do not confuse a refund with some form of extra income. Extra income is something like the Canada Child Benefit or Old Age Security--money from the government that is not really paid by you but which you receive on a regular basis because you meet certain criteria. A refund is getting your money back because you paid too much to begin with.

Put it this way... you go to the store and buy a pair of pants that cost $100 but was marked 20% off. The clerk made an error that you didn't immediately notice and charged you $100 plus tax. You paid full amount, stuffed the pants into your backpack, hopped on your bike and were halfway home when the thought crossed your mind that you paid too much. You check your receipt and sure enough the discount wasn't calculated, so you bike back to the store and get your $20 back.

Did you earn back that $20 from the store? Absolutely not! You made the purchase expecting the discount amount so you are simply getting a refund because the store collected to much money from you in the first place. It's actually inconvenient because you wasted your time, effort, and dignity by going back to the store and grubbing for that $20 you never should have paid in the first place. This simple mistake makes you obliged to the store rather than the store being grateful for your business.

Tax refunds work the same way. Your employer follows some standardized criteria to deduct money for taxes from each paycheque all year long. It's not tailored to your personal situation and is actually designed to make sure you pay more than you need to.

By giving the illusion of having the government owe you rather than you owing the government, you are now at their beck and call. You will file your tax return on time, you will appreciate anything they give you back, and if they dispute something you've done on your return, they hold back money which is rightfully yours until you prove yourself innocent.

The government wants to give you a refund because it's insurance. Also, it ensures they get paid first and it gives them an interest free loan that grows all year. If five million Canadians get an average refund of $500 every April, that's an accumulated free loan of $2.5B every year.

If you get a tax refund every year, especially a big one, you are doing something wrong. You should first ask your employer for a TD1 form. This form allows you to direct your employee to adjust your tax deductions lower for things like the age amount, caregiver amounts, education amounts, and disability amounts.

Next you need to look at the T1213 Form. The T1213 must be sent to the CRA after you complete because they must provide approval before your employer can reduce tax deductions. The T1213 allows you to deduct things like RRSP contributions, child care expenses, family support payments, investment loan interest expenses, and many other items.

By completing a TD1 and T1213 accurately, you should be able to drastically reduce the amount of your tax deductions each paycheque and the size of the tax refund every April. The only downside is this must be done every year, however the pay-off is worth the postage stamp.

Pay a Little More Tax

This might sound a little counter-intuitive, but if you are doing your tax preparation correctly every year you should actually be paying the CRA a small amount after your tax returns are done each April. I'm not talking thousands of dollars that you can only pay with a line of credit because you don't have the cash on hand, but a moderate amount that you can afford is perfectly fine.

While your co-workers brag about the size of their refund, calmly cut the government a cheque and understand you are better off for it. Not unlike using a credit card to collect points or cash back, it's alright to be in debt to the government as long as you pay them back when you are supposed to.

Enjoy filing your taxes in the next few weeks and if you are getting a refund, check out the TD1 and T1213 to make sure it doesn't happen again! Of course, if your refund is due to RRSP contributions make sure you put that money into your investment account because you will owe taxes on RRSP withdrawals down the road. If your refund is not because of RRSP contributions, still invest it and put that money to work for your future self!

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.