RRSP Loan Strategy

Written by FrugalTrader on Feb 11, 2008 filed under Retirement

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

15 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