Say you have maxed out your taxed advantaged accounts such as the RRSP and TFSA. What are my options now?
One solution is to borrow to invest. Check out this blog post for more details. Quick recap, essentially you borrow from the equity in your home to buy a low dividend broad market index fund. As an example, borrow 500K from your home at 3.5% and invest in a broad market (VUN.TO) index fund at an average total conservative yield of 8.5% to net $25k a year in tax free growth. On paper you would have a loss of 2% every year because VUN.TO pays a dividend of ~1.5% and your borrowing costs are 3.5%. This loss can be applied against your employment income yielding a nice $3,000 tax refund at year end (2% paper loss x 500k = $10,000 x 30% tax bracket= $3000 tax refund). Also the capital appreciation of the index fund is not realized until you sell, in early retirement not a single cent in taxes is paid if you planned it right 🙂 Okay with that said moving onto RESPs.
Another option to tax shelter money would be to open a RESP for yourself. You can open an RESP for yourself at any age. As an adult you would not receive any sort of grants in the RESP. However, you would still receive the tax advantage benefits. You do not need to go back to school to take advantage of this account type, but it is recommended that you use the RESP to fund education that interests you. Personally I would use my RESP to fund the 6 month home electrical foundations program at my local trade school in retirement giving me access to the full RESP balance.
How much can I contribute to my RESP.
You can contribute a maximum of $50,000 to the RESP. You can do this all at once or over time. You can only earn a maximum of $50,000 on those investments. So once your account reaches $100,000 (if you contributed $50,000) you have maxed out the RESP.
How do I pull the money out in the future
If not going to school, any amount in the RESP should not be needed for at least 10 years. Contributions can be taken out of the RESP at anytime but in order to withdraw any investment earnings (account balance – contributions=investment earnings) you must follow a certain set of rules. If you don’t follow these rules you forfeit the some of the interest earned on your contributions. Following the rules, the investment earnings can be transferred to your RRSP tax free with out penalty.
“You may be able to transfer up to $50,000 of earnings tax-free from the RESP to your RRSP if:
- the RESP has been open for at least 10 years;
- all beneficiaries are at least 21 and not currently continuing their education after high school;
- you have room to add money to your RRSP;
- you are a Canadian resident; and
- the rules of the plan allow it.”
Once the above rules are satisfied, we can use a drawdown strategy bring the RESP balance to zero. In order for this drawdown strategy to work, there must be some earned income in retirement. This earned income can be from rental income or from business income. Personally, I will have rental income in retirement. It is very rare to not have any sort of earned income in retirement as an early retiree. CPP and employer pensions even counts as earned income. The reason we need earned income is to create RRSP room in order to transfer the RESP to RRSP. Once the funds are transferred from your RESP to your RRSP, you can then withdraw those funds from you RRSP strategically. If although rare, you do not have earned income in retirement then you can still withdraw from your RESP, but the investment earnings will be taxed at your current marginal rate plus a 20% penalty. If you have zero income in retirement, then your marginal rate will be zero up to your personal exemption amount. However, you would be still subject to the 20% penalty, so it likely would not be worth it to open an RESP if you don’t have a way to build RRSP room in order to avoid this 20% penalty. If however, based on your risk tolerance, you hold investments that provide income such as REITs and Bonds that are taxed at your marginal rate then you may save a few percentage points by paying the 20% penalty when your marginal rate is zero.
As an example
The day before I retire I put $50,000 into my RESP. During the next 10 years I earn 3.6% in conservative investments. At the end of the 10 years, my RESP balance will be 71,627.00. My investment earnings are $21,627.00. During those same 10 years I had a net rental income of $12,000 average per year. During those 10 years I earned $21,600 in RRSP room due to my rental income ($12,000×0.18% x 10=$21,600 in earned RRSP room). Because my personal exception amount is around $12,000 it did not make sense to make RRSP contributions which is why I have RRSP room after 10 years. I can then transfer my entire RESP investment earnings (21,627.00) to my RRSP completely tax free without penalty. My original $50,000 is returned to me. Then at some point I no longer have earned rental income (some reasons could include: my parents move into my rental suite or I sell the rental property). Because, I no longer have earned income (can now utilize my personal tax exemption amount) I can strategically withdraw the new 21,627.00 balance from my RRSP over the next two years completely tax free. Defiantly a lot of planing and things that need to go right here.
This RESP tax advanced strategy applies to you if:
- You have exhausted all other avenues of tax efficient sheltering, such as TFSA, RRSP, LIRA, Borrowing to invest, earning too much in Canadian dividends (generally over 50,000 a year).
- Possibility of going to school in retirement but not necessary.
- Will have earned income in retirement such as rental income or business income.
- Comfortable with a very conservative portfolio paying less than 7% per year, you can only earn $50,000 total in investment income, which if you contribute $50,000 at the beginning then after 10 years you would have hit the maximum 50,000 investment earnings limit at a 7.2% interest rate ($50,000 x 1.072^10=$100,000).
The RESP is a last resort for tax sheltering for the early retiree. There are many rules to follow and if things don’t work out as planned, you could ended up paying a 20% penalty on investment earnings in addition to taxes at your current marginal rate. I think there are better ways to tax optimize your money. If however, you have plans to go back to school in retirement for fun, such as trade school or anything else that interests you, then this strategy will actually make a lot of sense as it allows you to access the full RESP balance within 26 weeks of full-time schooling*. If you are planing to go to school then I suggest you open a RESP as soon as possible. This article was meant as an overview of how the RESP could possibly be used as a tax shelter for the early retiree , consult the RESP website for details when planning your retirement finance hacking.
*If you are going to school full-time or trade school, you can withdraw $5,000 ($2,500 for part-time studies) during the first 13 weeks from the RESP . After 13 weeks you can then withdraw the remaining balance! Keep in mind the funds used for school is still taxed at your marginal rate. However, likely your income on paper will be low enough to avoid paying taxes on the RESP withdraws for school, especially when you combine it with the tuition tax credit. I wrote another blog post on how you can go to school for free in BC leaving the full RESP balance in your pocket tax free.