To borrow or not to borrow an RRSP loan
Make sure you have decided on a repayment plan before signing the bank’s dotted line
February is RRSP season, which for many Canadians means an annual trip to the bank to make an RRSP contribution before the deadline (March 1, 2017).
It might be tempting to take out a loan if you don’t have the cash available to make a contribution — the rationale being that in one shot you’ll boost the savings in your retirement account and then use the deduction to increase your chances of getting a tax refund.
But an RRSP loan is also a two-forone special for the bank: a loan, plus an investment on their books. No wonder our financial institutions so heavily promote RRSP loans at this time of year.
It’s not only Canada’s Big Five banks that are praising the benefits of taking out an RRSP loan. Online banks and lenders are also getting in on the act.
Most RRSP loans are used to make an RRSP contribution before the deadline to maximize contribution room and save on taxes.
Interest rates on these loans can be obtained at or near prime rate, and the loan is paid back over a period of nine to 12 months — typically in monthly installments. Borrowers beware Despite the efforts put forth by salespeople and promotional material telling you that an RRSP is a good idea, it may not be best for everyone.
A chart that tries to highlight the tax savings on an RRSP contribution, for example, might show a borrower in the highest marginal tax rate to make the figures look good. If you happen to be in a lower tax bracket, you’ll get less of a refund.
One behavioural argument against taking out an RRSP loan is that if you didn’t have the discipline to contribute regularly to your RRSP throughout the year, how do you expect to stick to a loan repayment schedule over the next 12 months?
Financial author Talbot Stevens says our behaviour is the key to making the RRSP loan strategy successful.
“Even an undisciplined investor can benefit from the forced savings of paying off a loan — as long as it is well within their financial and emotional comfort zone,” he says.
Small top-up loans are generally accepted as a sound financial planning strategy and Stevens argues that once started, the RRSP loan becomes a forced savings plan, like a mortgage, that is not likely to be stopped.
With that in mind, let’s use an example of an investor who is in a 40per-cent tax bracket, has $1,000 to contribute to her RRSP before the deadline and has $5,000 in available contribution room.
A short-term loan can top-up her annual RRSP contribution to the maximum. She simply borrows the extra $4,000 to make a $5,000 contribution and, at tax time, she’ll receive a $2,000 refund. The refund is not enough to pay off the entire RRSP loan, but she applies it against her loan and then pays off the remaining $2,000 balance over the next year. This type of approach can boost your retirement portfolio in a hurry, but it can also lead to an endless cycle of borrowing ahead to catch-up on RRSP contributions.
With a loan repayment eating up a large slice of your budget every month, will you be able to afford to make regular RRSP contributions going forward? In other words, at the end of the RRSP loan, you might have to catch-up the contributions you didn’t make while you were repaying the loan.
A debt-free approach would have you calculate the amount you would have made in RRSP loan payments, then use that amount to make regular RRSP contributions going forward. It may take a while longer to catch up, but you’ll have no interest costs.
Using an RRSP loan can be a powerful strategy to boost your RRSP contributions and build your retirement portfolio.
However, use caution when borrowing to invest and remember that this approach only works when you have the discipline to save your tax refund or use it to help pay off the loan.
Lenders play into our need for immediate gratification. Saving and investing are long term, slow and steady propositions.
If you want to catch up on RRSP unused contribution room, trim back your expenses or find a way to make some extra money and then sock away an appropriate amount.
“Truly disciplined investors don’t need the forced commitment of an RRSP loan. Those who acknowledge their tendency to procrastinate or become distracted from their retirement goal might benefit from the forced discipline of making payments on an RRSP loan,” Stevens says.