I routinely come across people who get an annual RRSP loan – so I thought I would talk about this common strategy – although I personally think there are better ways of saving regularly to an RRSP (i.e. without having a constant interest cost!)
In a nutshell – you borrow money from a bank in order to make a larger lump sum contribution to your RRSP before the contribution deadline. This allows for a large tax refund, which is then applied to the outstanding RRSP loan balance. You can then choose to lower your monthly RRSP loan payments or shorten the duration of the RRSP loan due to the lump sum repayment from the tax refund.
Many people find it hard to "voluntarily" contribute to their RRSP’s on a regular (i.e. monthly) basis. In fact, some people find that they take out the loan because they are less likely to miss a loan payment then they are to miss a voluntary contribution. I suppose we can blame this on the tendency for people to finance everything as opposed to saving up for it first.
Since many people are in this situation, or frame of mind, I will present the traditional RRSP loan strategy – although it does have it’s drawbacks as I alluded to at the beginning.
We already know that whatever money you contribute to your RRSP (up to the amount of contribution room you have) earns you an income deduction. As a recap, let’s say you earn $50,000. Your taxes that are with-held at source (at your employer) are based on you earning $50,000. But in the eyes of the government, if you actually "earn" less – remember the RRSP contribution reduces your earned income – then you will have overpaid your taxes. So if you made a $5,000 contribution to your RRSP, your earned income for the year will be $45,000 – not $50,000. That means you will have paid too much tax, and hence you get a refund at tax time.
Since many people do not budget effectively or save regularly, they will wait until the last minute to think about making their RRSP contributions. The combination of the pressure to save for one’s retirement PLUS the dangling carrot of fat tax refunds has led to the growth in RRSP loans (and RRSP loan marketing by the financial industry).
So let’s look at the math for someone who earns $50,000:
First we would look at how much total tax that person would pay if their earned income was $50,000. According to the tax calculators at Ernst & Young’s website (as of tax legislation in place May 31st, 2007), they would be on the hook for $10,157 in tax (very depressing, I know).
To figure out how much they can save in tax with a $5,000 contribution to their RRSP we can look at the total amount of tax owing for someone earning $45,000, and then subtract that amount from the tax bill for the $50,000 income earner. A $45,000 income earner would owe $8,599 in tax.
So, subtracting $8,599 from $10,157 leaves us with a tax savings of $1,558. A good way to double check is to use the handy "RRSP Savings Calculator" (also on Ernst and Young’s website) which will let you enter your Taxable Income and RRSP Contribution – it will then calculate your tax savings for you. In this case, it spits out $1,558 – which confirms our math.
Okay, so that was easy. But don’t forget that we now have a loan that needs to be paid off!
The duration of the loan will have a big impact on the monthly payments, but if you are planning on making an annual contribution you’ll want to have it paid off in 12 months, correct? That being the case, a $5,000 loan will cost you around $430/month for 12 months (assuming a 6.5% interest rate).
Once the tax refund arrives - which should be around the middle of June (assuming you filed on time) – you can then put the refund towards reducing the loan balance outstanding. Like I said, you can choose to either reduce the monthly payments from that point on, or continue with the $430/month and have the loan paid off early.
A feature that has become common with RRSP loans is the feature of "first payment deferral" and you normally have the option deferring your first loan payment for a period of 3 or 6 months. This feature is designed to explicitly address the fact that your tax refund does not arrive until mid June, but you need to make your RRSP contribution by the end of February.
I would suggest that if you feel the need to choose a 3 or 6 month deferral – you probably shouldn’t be getting such a large RRSP loan if your ability to make the regular monthly payments is dependent on your refund. You should be able to comfortably carry the loan payments without that tax refund – otherwise you might be stretching yourself a bit thin – and that only leads to more money stress!
It would be preferable to elect to make your loan payments from the time you first get the loan and then apply the refund to the loan balance and then reduce your payments at that point. Like I said, If you are able to make the regular monthly payments until the refund comes in, then I think that is a good indicator that you have not over-extended yourself.
So in our case, the monthly loan payment of $430/month would start on May 1st (roughly 30 days after the loan was set up). If the tax refund of $1,558 came in mid-June and then was applied to the loan balance, you would then have the choice of reducing your monthly payments to around $360/month OR you could reduce the term of the loan by about 2 months by keeping your payments at $430/month.
And that is the traditional RRSP Loan Strategy. As you can tell, I’ve been on an RRSP theme as of late and I will be talking about some other RRSP loan strategies in the near future. I suppose most people will be hearing about RRSP’s in January/February – but I think by that time it’s a bit too late! (That’s probably a reason why the RRSP loan has become so popular!) :)
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