Some points to consider when using loans to augment savings
The maximum RRSP deduction limit has increased to $20,000 in 2008. Those with an income of $111,111 or greater may qualify for this upper limit. Members of a defined benefit pension plan will have to factor in any current and past pension adjustments. Most people have salaries below this amount and often it is not easy to maximize annual contributions to an RRSP.
As the deadline for RRSP season approaches many investors may be asking if they should borrow to invest in their RRSP. The answer really depends on your financial situation. If you are contemplating borrowing to make an RRSP contribution we recommend you consider these following points:
The greater an individual’s taxable income the more it makes senses to maximize RRSP contributions. Reducing your tax liability is often a motivating factor for many individuals when making an RRSP contribution. Those in the higher marginal income tax bracket should speak with their advisor. Even if you do not have the cash on hand to make an RRSP contribution it may make sense to borrow the funds to make a contribution by February 29th.
Individuals who are considered “employees” may receive a relatively stable monthly income that is predictable from year to year. Business owners and entrepreneurs generally have fluctuating income resulting in a higher tax bracket one year and a lower tax bracket in another. RRSP contributions may provide a unique way to smooth your taxable income. Individuals may have one time spikes in income from selling a real estate investment or other type of investment that generates a significant capital gain. Planning to utilize a portion of your RRSP contribution room to offset this future liability may make sense.
Term of the Loan
Interest rates are currently relatively low making borrowing for an RRSP fairly attractive. Most financial institutions provide RRSP loans; however, the rates can vary considerably. The better the terms of the loan the more attractive borrowing becomes. Some individuals may choose to utilize their lines of credit, which may have favourable rates and the greater flexibility for repayment. Business owners may want to utilize an RRSP loan rather than their lines of credit, which have been set up for emergencies.
Length of Loan
The general rule-of-thumb is that the quicker you pay back the RRSP loan the more advantageous it is. Short-term loans of less than a year may have minimal interest costs and may assist those with fluctuating income. The more difficult question is when do larger, longer-term loans make sense? Long-term loans are often used to catch up on a significant amount of unused contribution room. With longer-term loans it is even more important to weigh the other factors in this article.
Carry Forward Room
Prior to 1991, individuals lost their RRSP deduction room if they did not fully utilize it in a given year. The good news is that unused RRSP contribution room may now be carried forward indefinitely and includes any unused RRSP deduction room accumulated after 1990. The bad news is that if you wait too long then you’re missing the biggest benefit of an RRSP – the compounding growth that may occur on a tax deferred basis. Regardless of the timing, we encourage most individuals to utilize their carry forward room prior to retirement.
Interest on a loan for your RRSP is not tax deductible. However, money borrowed to earn non-registered investment income may be deductible. This is why it may make sense to use extra cash to contribute to your RRSP and borrowed funds for non-registered investments. If you have non-registered investments and are considering an RRSP loan you should meet with your accountant first. There may be a way you can arrange your finances to ensure that more interest costs are deductible.
Return on Investment
This is perhaps the most difficult component for people to analyze. If you knew with certainty the investment returns you would obtain then the decision may be easier. Let’s step back and disregard how your investments may perform in the near term. An RRSP is normally established with a long-term time horizon. The focus should be on picking the highest quality investments that will prevail in the long run, regardless of market volatility. We understand that many people scramble to make a last minute contribution to their RRSP. This is okay provided care is taken when making the investment decision. If the energy is focused on picking the best investments and the best advisor, then an RRSP loan may make sense.
Last year we highlighted a simple strategy that investors could adopt to ease the cash flow burden of trying to come up with their RRSP contribution limit every tax season. Let’s consider an investor with a $20,000 RRSP contribution limit for the upcoming year. For this investor we recommend multiplying their RRSP deduction limit by 75 per cent and dividing by 12 to obtain the monthly pre-authorized contribution amount of $1,250. In either January or February of the following year, the investor could utilize their line of credit or obtain a short term RRSP loan to contribute another $5,000 to top up to the maximum. After filing the tax return, the combined RRSP contributions of $20,000 may provide enough of a tax refund to pay off the short-term loan or line of credit. This of course assumes that sufficient tax was withheld on other sources of income throughout the year.
The above strategy is a combination of “automatic” savings by paying yourself monthly and a “forced” short-term loan strategy that creates the discipline to pay off the loan as soon as possible. This combination has worked well for many successful investors.