Tuesday, October 10, 2017

Liberating Your Losers

Recently, Jonathan Chevreau wrote about a way to try to save money on taxes called “liberating your losers” from your RRSP. It’s no fun owning a losing investment, and when it’s in your RRSP, you don’t even get a capital loss for your taxes. Chevreau offers a way to reduce the sting. Unfortunately, it doesn’t work.

The idea is to withdraw a losing investment from your RRSP so that when it rebounds, you’ll only pay capital gains taxes on 50% of the increase. If you leave the investment in your RRSP you’d end up paying taxes on 100% of the increase when you eventually withdraw the assets from your RRSP/RRIF.

According to Chevreau’s broker friend, this makes sense “when you have had bad timing in your RRSP/RRIF investment choices; when you're confident your investment will return to its previous higher value; and if you prefer to pay tax on 50 per cent of a capital gain rather than 100 per cent of income.” The first condition just means you’ve made an investment that lost money, and the third condition is that you’d rather pay less tax.

Unless you’re Warren Buffett, the middle condition (that you’re confident the investment will rebound) requires you to hallucinate that you have investment skill that makes your judgment of the investment’s value better than the collective judgment of all other investors. If this is true, why not invest more in this investment that’s sure to rebound? The truth is that this investment is no more likely to generate future profits than any other investment you might choose in the same class. However, even if you’re right about the investment rebounding, the strategy of liberating your losers doesn’t make sense, as I’ll show.

To avoid making mistakes analyzing investments inside and outside RRSPs, it helps to think of part of your RRSP belonging to the government. If you expect to pay 40% tax on RRSP/RRIF withdrawals, then think of your RRSP as only 60% yours. Whatever gains your investments make in the future, the government will get 40%, so you might as well think of 60% of the money belonging to you and growing for you, and 40% for the government. The government bought this slice of your RRSP back when you got a tax refund on your contribution.

Thinking about the government owning a chunk of your RRSP isn’t pleasant, but it can keep you from making mistakes when thinking about different strategies. A silver lining is that the 60% of your RRSP that’s yours is completely tax-free. All the taxes you owe are taken into account by allocating 40% of your RRSP to the government.

Getting back to the strategy of liberating your losers, let’s consider an example. Suppose you invested $25,000 in XYZ stock within your RRSP a few years ago and its value has dropped to $5000. Now you’re considering liberating your losers and hoping to save on taxes. The truth is that only $15,000 of that initial investment was yours, and only $3000 is currently yours. If you withdraw your XYZ stock from your RRSP, you’ll have to pay $2000 in income taxes.

By doing this you’re actually increasing your stake in XYZ stock. Before the withdrawal, you really only owned $3000 worth of XYZ stock, and afterward you owned $5000 worth. This suggests an alternative strategy: leave the XYZ stock in your RRSP and buy $2000 worth of XYZ outside your RRSP.

Let’s name these strategies “liberate” and “buy more.”

Liberate: Withdraw $5000 worth of XYZ stock from your RRSP and pay $2000 in taxes.

Buy more: Leave the XYZ stock in your RRSP and buy $2000 more XYZ for you non-registered account.

Suppose XYZ stock doubles. Which strategy is better? In the liberate case, you own $10,000 worth of XYZ stock in your non-registered account, and you have a $5000 capital gain that will generate $1000 in taxes when you sell.

For the buy more strategy, you have $10,000 worth of XYZ in your RRSP (of which only $6000 is really yours), and you have $4000 of XYZ in your non-registered account for a total of $10,000 worth of stock. You have a $2000 capital gain that will generate $400 in taxes when you sell.

One difference between these two strategies is that you’ll pay more capital gains taxes with the liberate strategy. Another is that further gains will generate more capital gains taxes with the liberate strategy. This is what I assume Jamie Golombeck meant when Chevreau quoted him as saying “But you then lose your tax-free compounding indefinitely, which is why I don't like it.” It’s clear that the buy more strategy is superior.

But what about all the extra tax you’ll pay when you ultimately sell your XYZ stock and withdraw the money from your RRSP/RRIF? It’s true that the government will get more tax with the liberate strategy. But that’s because you invested $2000 in XYZ stock on the government’s behalf in your RRSP and it doubled. With the buy more strategy, both you and the government came out ahead. Unless you hate the government so much that you’d rather both lose than both win, I suggest just focusing on your own after-tax gains.

Does liberating your losers make sense if you’re forced to make a RRIF withdrawal, but you don’t need the money to live on? The short answer is no. In this case, the “buy more” strategy changes but is still superior to the liberate strategy if XYZ stock is going to perform better than your other investments.

The alternative to liberating XYZ stock begins by choosing $8333 worth of some other investment(s) within your RRIF that you think will perform worse than XYZ. Sell 40% of these investment(s) and buy XYZ stock with the resulting $3333. Use the remaining $5000 of the investment(s) to make an in-kind withdrawal from the RRIF. If XYZ outperforms the other investment(s), then after working through the details, you’ll find that this strategy works out better than liberating your losers.

In summary, liberating your losers is a bad idea. It only seems good when your understanding of RRSP/RRIF taxation is muddled.

4 comments:

  1. Well done! I like your concept of mentally separating RRSPs into two accounts. It really helps clarify strategies that work...such as drawing down RRSPs in low or no income years. This moves money from the government account directly into your personal account.

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    1. @Garth: Glad you like it. Yes, when you draw down your RRSP in low-income years, you get an immediate tax advantage, but you lose some long-term tax-free growth. It's a trade-off.

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  2. Moving cash out of RRSP in low income years would be a clear win if the money was used to invest, particularly within a TFSA. Unfortunately the scenario is likely quite rare.

    Never heard of "liberating losers" but yeah... Not helpful.

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    1. @BHCh: For someone with TFSA room that wouldn't get used otherwise, pulling money out of an RRSP in a low-income year makes sense. For someone who'd have to invest in a non-registered account, you're balancing the tax savings on the RRSP withdrawal against the lost tax-free RRSP compounding in the future. This can go either way depending on the numbers.

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