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financial planning

Like Timbits and shinny hockey, RSPs are almost part of our culture. We all know about the benefits of getting a tax refund every year, but did you know what happens when you have to "pay the piper"?

For many Canadians, the biggest tax hit they will ever face is if they pass away with a big RIF or RSP balance.

If you talk to someone who has had to deal with the estate of their parents, many will tell of the shock of finding out that almost half of their parents' RSP or RIF went to the government.

Here is how the tax works:

• An RSP grows tax sheltered until you draw money out. All money drawn out is treated as income for tax purposes.

• While you can draw money out at any time, many Canadians (if they can do so) wait until they are in their 72nd year, when they are forced to start drawing out a minimum of 7.48 per cent of the value of the RIF. This may not be the best approach.

• If you are married and one partner passes away, if set up properly, the RSP or RIF will transfer to the surviving spouse without any tax being owed.

• The problem is if you are the last surviving spouse. When this person passes away, unless there is a disabled child, the entire value of the RSP/RIF is considered to be taxable income on your final tax return. In Ontario, if you have a $500,000 RIF at that point, the government will take at least $212,000 in tax!

How do you avoid this huge tax hit?

1. Don't save so much in your RRSP in the first place. This may not be a concern if all of your RSP contributions end up giving you the maximum tax refund because you are in the top marginal tax bracket. In that case, the RSP contribution probably makes sense. However, if you are in any other tax bracket, it may not make sense to contribute if you are likely to have a big tax hit at the end. This decision needs to be thought through based on a lifetime financial projection.

2. Draw more money out while you are able to enjoy it. From a pure financial perspective, you want to draw out registered money in years when it can be done at a lower tax rate - those years when you have very little other income. From a philosophical point of view, you want to draw out the funds when you are still able to enjoy it. It doesn't do much good to be forced to draw out $100,000 if you are in poor health and can't enjoy the money. Better to draw it out sooner.

3. You can use strategies like the RSP meltdown to effectively draw out more money from your RSP by creating a tax deduction equal to the amount withdrawn. This strategy is meant for someone with a paid off home or with a lot of real estate equity, as well as a large RSP or RIF. The idea is that you would take a mortgage or line of credit on your home and invest the funds in a relatively conservative income portfolio. The interest you pay on the loan is tax deductible, so if you pay $10,000 in interest, you can withdraw $10,000 from your RSP. The extra taxable income from your RSP withdrawal would be eliminated by the tax deductibility of the interest. If the investment portfolio can return just 5 percent, it is the equivalent of a tax-free RSP withdrawal.

This strategy can be quite effective for many people, but does require some leveraged investing. Given our historic low interest rates, this strategy is lower risk today than it ever has been - but isn't right for everyone.

The main message here is that you should be aware that a large RSP can be both a blessing and a tax curse. If you plan your strategy well in your 50s and 60s, you can often avoid the surprise and pain of a huge tax bill for your estate.

Follow Ted Rechtshaffen on Twitter: @TriDelta1