RRSP Loan Strategy
What is an RRSP Loan? It's a loan, typically offered at prime, that allows the borrower to contribute to their RRSP using the banks money. The upside is that the borrower gets the tax refund in a few months, the downside is that the borrower is stuck with a loan that is paid out of cash flow.
To be upfront with you, I'm not a big fan of RRSP loans. The only way that I would consider a RRSP loan is if the total tax return would cover the WHOLE loan.
In other words, I would only borrow to "top up" my contribution (if I had the contribution room) so that my tax refund will be enough to pay off the underlying loan.
Below is some boring math that I figured out. For those of you who bore easily, skip to the final equation.
RRSP Loan Amount (RL) = Total Tax Refund (TR)
TR = RRSP Contributions (RC) x Marginal Rate (MR) + RL x MR
Since we want: RL = TR
RL = (RC x MR) + (RL x MR)
RL – (RL x MR) = RC x MR
RL (1-MR) = RC x MR
RL= RC x MR/ (1-MR)
In plain English:
RRSP Loan = (RRSP Contribution x Marginal Rate) / (1 – Marginal Rate)
So to use this equation, say you contributed $5k to your RRSP this year @ 40% marginal rate. If you have the contribution room and considering using a RRSP loan, I would only get an RRSP loan the size of the tax refund.
Therefore,
RRSP loan = $5k x 0.40/ (1-0.40) = $3333
Working backwards:
Tax Refund = ($5K x 0.40) + ($3333 x 0.40) = $3333
This strategy works best if you initiate the loan/contribution just before the RRSP contribution deadline (Feb 29, 2008) as it would minimize the interest costs. Note that the above formula does not account for the loan servicing costs incurred over the few months while waiting for the tax refund.
Cue geek jokes…
Photo credit: ansik
23 Comments, Comment or Ping
1. Four Pillars
I agree with you – other than for the purpose of “forced savings”, there isn’t any benefit for the normal investor.
There are some special situations where it makes sense such as if you are about to retire and have some room or if you are taking a year off and want to buy more rrsps at a higher marginal rate and then cash them in the following year (when you are not working). Just a thought.
Mike
Feb 11th, 2008 @ 8:12 am
2. George
I’ve used RRSP loans in the past (actually, I just borrowed a bit from our line of credit), but the loan was paid off within a month or two of receiving the tax refund; the total interest costs were pretty minor – easily under $50.
As to your comment about waiting for the refund, who still waits “months” for a tax refund anymore? I’ve used Netfile for the past five years or so, and every time I’ve received my refund within 10 days after filing, sometimes even sooner!
Feb 11th, 2008 @ 10:05 am
3. WhereDoesAllMyMoneyGo.com
I would add a word of caution when using marginal tax rates for calculating your RRSP refunds. Some tax brackets are very shallow (for example, the 39.41% tax bracket in Ontario only exists between 73,623 and 74,357. The next tax bracket down is 35.39%.
Here’s an example of how this can catch you out:
Let’s say an Ontarian earns $75,000/year. If they made a $5,000 contribution to their RRSP one might be tempted to look at their marginal tax rate of 43.41% and multiply that by $5,000 to yield: $2,170.50 tax refund. But since contributing $5,000 will drop them down two tax brackets their actual refund would be closer to $1,826.
Feb 11th, 2008 @ 11:54 am
4. nobleea
I guess it depends on the difference between your loan interest rate and the rate of return you get in your rrsp.
I’ve sometimes thought that it is better to take an rrsp loan out that would be paid off in the year. For example, if you contribute $500 a month to your rrsp, then get a $6000 loan and by the end of the year, it will be paid off from your monthly contributions (except your monthly contributions are now loan repayments instead). The benefit is that the whole money has a chance to grow for the full year, rather than just a bit if the year if it were invested gradually. If the rrsp rate of return was the same as your loan rate, then you’d be behind (aside from getting the tax refund a year early). There’s some rrsp rate of return at which point it would make sense. I don’t know what it is, probably 8%. (correction, after doing a quick spreadsheet, i think it’s around 1% above your loan rate)
Feb 11th, 2008 @ 12:28 pm
5. Anna
I am facing a situation where I have about $6,000 tax bill due to the capital gains on the mutual fund I own. This is after my RRSP contribution of $13,000 for the year. Unfortunately I am short on cash as I am getting married in May of this year and most of my money is being eaten up by the wedding… So, the best thing in my situation is to take our RRSP loan to eliminate tax liability (since I have a lot of unused RRSP room) and then pay it off by July, after the wedding. Any thoughts? I am in the highest tax bracket.
Feb 11th, 2008 @ 12:45 pm
6. CheapCanuck
I would argue that RRSPs loans are pretty useless in general. I guess if one would normally blow their refund rather than putting it back into your RRSPs then it can act as a forced savings plan. But, on the other side of the coin, one might still end up blowing the refund and wind up paying interest on the loan for several more months. For those who make regular contributions and would normally reinvest their refunds anyways it doesn’t make sense either. The interest on the loan would essentially wash away any benefit of getting the money in earlier (and that’s assuming the RRSP makes gains during this short time period – no guarantee at all).
Feb 11th, 2008 @ 1:11 pm
7. Quentin DSouza
I am using a couple of calculators that help in finding a more exact number for Tax Calculation purposes. Although, I’m sure there are many – Ernst & Young Canada is great.
http://www.ey.com/global/Content.nsf/Canada/Tax_-_Calculators_-_Overview
See the RRSP Savings Calculator.
Feb 11th, 2008 @ 1:49 pm
8. layman
im betting the farm and really not sure what to do with my chickens?
-selling the house taking 100k profit
-putting 50k in rrsp (maxing out)
-but using HELOC to do so till completion on house sale april 1st
good, bad? there’s also the possibility of a lower tax bracket in 2008 due to a career change.
Feb 13th, 2008 @ 8:30 pm
9. George
Layman: If I understand you correctly, you’re borrowing $50k from your line of credit from the end of February until early April – say, six weeks or so. Assuming that you’re definitely going to get the profit from the house sale and that you’ll be able to pay off the loan in full after the sale goes through, it sounds like a fairly good plan – the interest costs on the HELOC shouldn’t be more than $500, but you’ll have a significant RRSP deduction to use.
One thing to note: you don’t have to use the RRSP deduction in the same year that you make the contribution – you can “save” the deduction and use it in a future year. If your tax bracket will be lower in 2008, this might not be a good idea (you want to use the deduction, as much as possible, when you’re in a higher tax bracket to maximize the tax savings).
Feb 13th, 2008 @ 11:01 pm
10. layman
By George you got it :)
I can get 5.5% on the money for 90 days (3.74 after that) and my HELOC is 5.75% so I don’t think the actual cost will be anywhere near $500, but I do still need to confirm this account is registrable though. I also want to find out how much of it I can borrow from the Home Buyers Plan when I buy back in to Real Estate, I’m thinking a year or two from now, maybe longer.
Feb 14th, 2008 @ 3:16 pm
11. clueless
Hi guys,
Here’s my situation:
• I make about $92,000 / annually and my wife take home is around $72,000/ annually.
• Got our first RSP last September 2007 and contributed about $8,000 to date. Our last tax return indicated that we have $16k and $20k contribution room for our RSP.
• Roughly 5k in savings (it’s really small, though I am supporting two of my sibling educational requirement)
• Tendered to purchase a house for $420,000 with a closing date of June 30, 2008. (We are expecting our second child this year and we really need to move out of our one bedroom condo.
Our financial planner (Investor’s Group) suggested that we take out the max RSP loan (@ prime +1.5% spread over 10 years) to be used as down payment and use the refund either to cover the closing cost or invest it in a 4% preferred savings account.
Being fairly new to the country and having without a semblance of a family support, I am not confident that I am making the right financial choices. Thus, I would greatly appreciate any help/ you’d be able to provide.
Feb 17th, 2008 @ 3:21 pm
12. George
Clueless,
There are a lot of variables involved that make it difficult to give you specific advice – your age, assets, debts, and other obligations. Does your employer have a pension plan? If so, an RRSP might not be necessary. How much do you expect to pay for child care now that you have two children – I’ve got two kids, and my daycare expenses for 2008 will be nearly $20k! With potential large expenses coming up, going $36,000 into debt to fund an RRSP might not be the best strategy. Bear in mind that when you have a house, you’ll have significantly higher expenses than in a condo – you won’t have condo fees, but you’re responsible for all of your own maintenance and repairs, and property taxes will be significantly higher.
As a rule, RRSP loans only make sense if they’ll be paid off within a year. Also, RRSP loans are regularly offered at prime, so prime+1.5% doesn’t sound like a great deal to me. It’s odd that they’re recommending an “RRSP Loan” that’s really going to be used to provide a down payment for a house purchase.
I’d suggest getting a second opinion from a fee-only financial planner. Investor’s Group has a conflict of interest, since they make money from you if you take out an RRSP loan and invest with them – it’s in their best interest for you to invest as much as possible, whereas it might not be in YOUR best interest.
Also, you’re not likely to get good advice from random people on the Internet – we don’t know all of the details of your situation, and you have no reason to trust any advice you receive here. Hire an advisor that you trust, pay them an hourly rate for their services (instead of a commission on sales), and have them review your situation and give you advice.
Feb 17th, 2008 @ 4:13 pm
13. Clueless
Thanks for the advice George. Will certainly look for a fee-only financial planner.
Feb 19th, 2008 @ 11:30 pm
15. David Anstey
I had a good chuckle reading your advice about using a fee-only planner. Most fee-only planners I’ve met base their fee on size of your portfolio and not on a per-hour basis. So an RRSP loan still increases your portfolio value – hence the perceived conflict of interest still is there.
The biggest factor in determining whether an RRSP loan is beneficial is what you do with the tax refund. If you invest it, or use it to pay down the loan the strategy is generally sound (keep in mind that an RRSP loan is a leveraging strategy like any other and is dependant upon market performance). Where the strategy really holds up is when you use the tax refund to pay down really high rate credit card debt. Most financial institutions will give you a low interest rate RRSP loan because they will hold the investment against the debt. You will find that they will not be as generous providing you a low interest fixed rate loan to pay off your 22% credit card in most cases unless you secure it against an asset. Thus the extent to which the strategy is successful is really dependant upon the alternatives available.
In my experience the approach is successful with young couples who have been undisciplined with their money and have accumulated some debt. You ultimately can reduce some of their anxiety, reduce the interest costs on their debt, and begin a forced savings plan all at once. BUT, and I’ll say this again BUT…. they have to understand that all they have done is reposition their debt…… they will dig a much bigger hole if they ring up the credit cards again.
Oct 8th, 2008 @ 11:22 pm
16. AJ
MDJ, I got a $6K bonus check for 2009 given to me in Jan-2010 (i.e., it will be part of 2010 income). However, the company did not deduct taxes from this check and so I will owe around $2500 on this amount (I’m in Ontario at the highest tax bracket).
I have about $20K RRSP contribution room. Is there a smart move I can make with this bonus check and the combination of an RRSP loan that will put me ahead (and not have me owing a lot of tax in 2010)?
Would appreciate your thoughts. Thanks…
Feb 8th, 2010 @ 5:12 am
17. FrugalTrader
AJ, if it was me, I would simply deposit the whole check into the RRSP to get the full deduction as you’ll get the max benefit b/c of your tax bracket.
Feb 8th, 2010 @ 9:40 am
18. Ally P
I hope you can give me your take about my situtation below:
My income this year is 34K and I already took out loan of 30K (as my advisor advised) to max out my contribution room in end of Feb. However, i just realized that my max contribution room is 26 K.( I have over-contributed 4000K, misinformed by my advisor)
I talked to my advisor and he said if that’s the case, I should file the 30K RRSP contribution in 2010 tax year instead, since I’m very likely to make about 52K in 2010 tax year, that I’ll will be able to claim more with the same 30K.
My question is, how’s the marginal tax rate/tax bracket determined?
Obviously I can’t file this year, or I’ll be charged 1% on the overcontribution. If I wait and file the 30K contribution next year, will I be in the 52K income tax bracket (thus getting more tax savings) OR will I be in the 20K (50K less 30Kcontribution) tax bracket.
I just knew this advisor a few months ago, he was telling me that I’ll get about 10K back with the 30K investment while I get the loan, that I can use that 10K to paydown my line of credit. But now, it doesn’t seem to be the case.
I felt a rushed when getting the RRSP loan, approaching the March 1st deadline, now i found out that I have to wait, and i doubt i could even get 10k if i file next year.
I really hope that i’m not making mistake here. IF i am, I am hoping someone can give me your opinion on this? thank you.
Apr 9th, 2010 @ 11:19 pm
19. FrugalTrader
Ally, personally I would not use that advisor anymore. Recommending someone making $34k per year to take out a $30k RRSP loan doesn’t make sense to me.
To answer your question, if you were to claim your $30k contribution on $52k income, you would basically report a net earnings for that year of $22k. IMO, claim enough to drop you to the lowest tax bracket for your province, then move the remainder to be claimed another year. Use any tax refunds that you receive, and pay down that RRSP loan.
Apr 10th, 2010 @ 12:16 am
20. Ally P
I just checked the marginal tax rate for year 2010 for Ontarion: (related to the figures I’ve mentioned)
@22K marginal tax rate is 20.05% (first $36,848)
@52K marginal tax rate is 31.15% (over $40,726 up to $64,882)
IF I contribute $30K in 2010 tax year, the marginal tax rate will be 20.05% (30k*20%) as opposed to 31.15% (30K*31.15%). Correct?
If so, would you recommend to claim about 11K of the contribution, enough to keep stay the 31.15% marginal tax rate? then. carry Forward the unuse contribution forward to later years?
I did not get your point when you mentioned ” IMO, claim enough to drop you to the lowest tax bracket for your province, then move the remainder to be claimed another year. Use any tax refunds that you receive, and pay down that RRSP loan.” I thought dropping to the lowest bracket has no point since the whole RRSP thingy is to take advantage of the getting more tax back while income is high, and pay lower tax while income is low (during retirement).
OR, should I be better off to contact my advisor, (yes, it doesn’t seem to make sense the more I think about it) to see if I can cancel this whole loan? — I think the loan contract is still new (one mth old), I might have a chance to cancel since the 1st payment hasn’t been drawn yet.
Sigh… not feeling so smart about myself. But I really appreciate your comment. Thank you.
Apr 10th, 2010 @ 1:22 am
21. FrugalTrader
Ally, yip exactly. Next year when your income is higher you can claim enough RRSP contribution to bring your taxable income down to the lowest tax bracket. That way, you get a tax refund of 31% of $11k. Since you’ve already contributed to your RRSP, the only way to close the loan would be to pay it off (afaik). Not all is lost though, just make sure to put any surplus cash (refunds etc) towards your rrsp loan (or higher interest rate debt). The absolute best thing to do in this case is to talk to an accountant before you file this year. S/he will know how to carry forward contribution amounts for future years.
Apr 10th, 2010 @ 8:10 am
22. Ed Rempel
Hi Ally,
Your problem is unfortunate, but your solution is right on. I agree with FT that you should not work with that advisor any longer. He clearly did not have your best interest at heart. IF there was a reason for the loan, he should have explained it to you.
To put some perspective on your situation, the benefits of RRSPs are that you can defer tax on income of investments in the RRSP and that you may be in a lower tax bracket when you withdraw than you are when you contribute.
Therefore, RRSPs are worth contributing to if you expect to be in the same or lower tax bracket when you withdraw them (probably after you retire).
With your income at $34K, you are in the lowest tax bracket at about 20%. When you retire, you might be in the same tax bracket or a higher one. If you will still be in the lowest bracket at that time, then it is worth it for you to contribute because you can benefit from deferring tax on your investment income. But if you will be in a higher tax bracket after you retire, then you are probably better off NOT investing in RRSPs.
Many seniors are effectively in higher tax brackets because of all the clawbacks on government income programs, so the odds are that you will likely be in a higher tax bracket when you retire.
In short, for people under age 65 earning under $11,000, RRSPs are not worth it at all because they are not paying tax. For people like you in the lowest tax bracket, it is probably still not worth it for you to contribute.
Once your income is over $41,000, you are into the middle tax bracket at about 31%. Here it is quite likely that RRSPs will benefit you, since you have a reasonable chance of being in a lower tax bracket after your retire.
This is why contributing so much while you are in a low tax bracket probably makes no sense. Whenever advice from an advisor makes no sense, you have to wonder if the advisor really had your best interests at heart.
Your advisor was also wrong when he said you would get $10K back on a $30K contribution. That would only apply if your income was $71K or higher.
So, what should you do?
Option 1: Unfortunately, it will be difficult for you to just cancel. You would have to file a formal complaint and fight for a settlement. Your advisor could possibly issue a Letter of Indemnity to have the entire transaction reversed, but that would cost him quite a bit.It you be up to you to prove that the transaction was inappropriate and that you did not understand the recommendation.
Option 2: Your advisor could issue a Letter of Indemnity to have the investment changed so that the investments are not RRSP. In that case, you cannot deduct the RRSP contribution, but you can deduct the interest on the loan every year. This may well work for you as a long term strategy, since you would be borrowing to invest and the investments should be able to make more than the investment loan over time. This would also probably cost your advisor nothing to do (although he may hesitate to do it because he may be unfamiliar with how to do it).
Option 3: This is your strategy. Carry the entire deduction forward until you can claim it at a higher tax bracket. If your income is $52K in 2010, then you can claim $11K at the 31% tax bracket. If your income stays at that level, you can deduct the entire $30K over 3 years, in which you would get $10K in refunds over 3 years. Do you expect your income to stay comfortably above $41K for the next few years?
Which is best for you? Probably either option 2 or 3, but which is best is more complex. It depends on your income in the next few years, your tax bracket after you retire, and your risk tolerance.
Option 2 may well be best in your case, but borrowing to invest is considered a more aggressive strategy that may or may not be suitable for you. The advantage is that the the RRSP deduction is a deferral (you will repay it when you eventually withdraw the RRSP), while the interest deduction is deductible every year.
Option 3 is the simplest and gets you the largest refund over the next 3 years, but may or may not be the biggest benefit for you long term.
I hope that is helpful, Ally.
Ed
Apr 10th, 2010 @ 11:51 pm
23. Ally P
I would like to thank both Ed and FT for taking the time and giving me detailed advice on my situation here. You’ve helped me a great deal in learning what options I have at this point.
The bright side of this is the market is in the recovery mode right now, and I am hoping the potential return of the contribution/investement could “outperform” the interest % of the loan. My income will most likely to stay above 50K for at least a few years. I will go with Option 3.
The only person I would blame for my situation here is myself.
I’m sure everyone is out there for his/herself. I admit it was naive of me to get psyched with the deadline. I should have done more research like what i’m doing here before I commit to the loan.
Afterall, he’s a loan expert, not a tax expert and he could make mistake too. I’ll take this as lesson learnt, and I hope I’m making the best out of this, of course, thanks for your advice. Like FT said, afterall, it’s not all loss. :)
Honestly, I wouldn’t even have researched so much about RRSP if this problem hadn’t risen. I have learnt so much in the past couple nights, and I am relieved to find a solution that I’m comfortable with, and the knowledge that’ll be useful for a loooong time.
Can’t thank you enough. You rock!
May the force of prosperity be with you. :)
Apr 11th, 2010 @ 1:46 am
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