This is just another idea you can use if you liked my series of posts on leveraging. I showed how you can mitigate some of the risk involved with leverages by capitalizing on the power of piggy-backing refunds. Specifically we looked at using the refund from the tax deductible interest from an investment loan (to a non-registered investment account), putting that into an RRSP to generate another refund and then using that refund to contribute to a second non-registered investment account.
Here is another strategy that will give you an instant return of around 70% on your out of pocket contributions to your savings:
1. Take out an interest only loan.
2. The interest is tax deductible and generates a tax refund.
3. The tax refund from the loan interest is contributed to your RRSP.
4. The RRSP contribution generates another tax refund.
5. The refund from the RRSP is contributed to an RESP for your child.
6. The RESP contribution generates a Canada Education Savings Grant (CESG) of at least 20% (up to certain limits).
Of course, getting an interest only investment loan is pretty risky in and of itself, so you can’t consider his strategy if you are anything BUT an aggressive to speculative type investor. Make sure to get the counsel of a professional (or two!) before implementing anything like this on your own.
Let’s look at a real life example. Suppose we had an investor in the top tax bracket in Ontario, which is 46.41%. He has a child and so has the ability to contribute to an RESP. To make the math somewhat easier to follow, I will figure out how much of an interest only loan he would get in order to have an annual interest payment of $1,000 per year (based on a 7% loan interest rate). It works out to $14,285.71.
Okay, so his out of pocket costs are going to be $1,000/year – how far will that get him?
$1,000 in interest will generate a tax refund of $464.10.
He puts the $464.10 into his RRSP, which generates a tax refund of $215.39.
The RRSP refund of $215.39 is contributed to an RESP for his child which generates a 20% CESG.
20% of $215.39 equals $43.08.
So with an initial out of pocket cost of $1,000, we have generated $722.57 of new money.
If you wanted to calculate the maximum interest only loan you would need to generate the most amount of tax refunds and CESG without going over any limits (I suppose just for "efficiency’s sake"), we need to work backwards:
The maximum CESG this person could generate would be $500/year (since he is in the top tax bracket).
$500 divided by 20% = $2,500 -> this is what he can contribute to the RESP to get the maximum grant.
$2,500 divided by 46.41% = $5,386.77 -> this is what he can contribute to an RRSP to get an RRSP refund of $2,500.
$5,386.77 divided by 46.41% = $11,609.92 -> this is how much loan interest he needs to pay to get a tax refund of $5,386.77.
$11,609.92 divided by 7% = $165,813.09 -> this is the value of the interest only loan he needs at 7% interest to be charged $11,609.92 in interest per year.
So working forwards again, his interest only loan of $165,813.09 would cost him $11,609.92 per year in interest and that would be his total out of pocket cost. Through the piggy-backing refunds and grant from there on, he would generate $8,386.77 in "new money". Again, this is over 70%.
Because we are generating so much new money, the risks involved in the interest only leverage are somewhat mitigated, to the point that you come out ahead even if you were being charged more interest on the loan than you are earning in your investments. (Mind you the CRA might have an easier time challenging the deductibility of the interest on that loan if that were indeed the case!).
While the strategy is very effective, note that you will not get a compounded 70% return on your money and the invested money on an ongoing basis. You would only get this "return" on the amount you spent on the annual interest costs to support the loan.