There was a reader question about the strategy of borrowing to invest in an RRSP instead of a non-registered portfolio (like the Smith Manoeuvre). Here is the question:
I have a readvanceable mortgage – Take your equity out as you pay your mortgage (max payment you can afford like in SM), and invest this equity in an RRSP. Receive tax refund end year, put that on mortgage, then withdraw equity again and continue the process.
Now I realize that in this scenario that you would not receive the interest deduction that you would receive for a non-registered investment, but instead would receive the normal return that an RRSP would receive. As far as I can figure the effect would be receiving a large tax refund in the present (by using RRSP) and smaller in the future, versus a normal SM where you receive a very small refund at first and larger in the future (on a continual basis I realize until the loan is paid).
Any comments on this hybrid RRSP- SM idea, I am certain others have considered this option before and knew reasons why it is either worse or not legal than the regular SM, but I’d like to know those reasons. Please advise.
To begin, lets go over the tax rules, benefits/disadvantages of each strategy.
- Tax refund on the contribution – thus larger tax return to put on mortgage.
- Investment loan is not tax deductible.
- All withdrawals from the RRSP are taxed at the marginal tax rate.
Leveraged Non-Registered Portfolio:
- Tax refund based on the interest to service the investment loan. Depending on the current interest rates, this can fluctuate. This tax deduction is small initially but will grow over time as the investment loan grows.
- Withdrawals are very tax efficient from a non-registered portfolio. Only 50% of capital gains are added to income, and dividends can be extremely tax efficient depending on the amount of other income during the year.
Having explained the tax rules, our resident calculator guru Cannon_Fodder has modified his Smith Manoeuvre Calculator to compare both strategies. This is the scenario and conclusions that he came up with:
Instead of borrowing home equity as it accumulates to invest in a non-registered portfolio, borrow to invest in an RRSP, and apply the full refund to the mortgage. This uses a readvanceable mortgage so there is a lot of flexibility to do this as each payment is applied.
So, I tweaked my SM Calculator to allow for this scenario. Here is what I found:
– $300,000 House Value
– $240,000 Mortgage @ 5%
– $1,395.85 monthly payments amortized over 25 years
– 8% investment growth rate
– 5.75% HELOC rate
– Marginal Tax Rate of 46.41%
It should be noted that higher MTR’s make the case for investing into an RRSP more favourable when compared to the ‘traditional’ SM.
Here are the outputs:
With SM –
– Mtg is retired in 21 years
– $240k HELOC that is TAX DEDUCTIBLE
– investment portfolio of $304,142 that is NON-REGISTERED
– Adjusted cost base (not including commissions) of $138,516
– Mtg is retired in 18.25 years. Therefore, run the scenario until 21 years still making ‘mortgage payments’ but the money now goes to paying the HELOC interest and anything left goes into RRSP.
– $240k HELOC that is NOT TAX DEDUCTIBLE
– investment portfolio of $395,143 that is in an RRSP
Assuming the same MTR as used above, the net of it is whether a $240k LOC that costs $13,800 after tax to service annually and a fully taxable portfolio of $395k (that would be worth $212k if cashed out all at once) is better than having a $240k LOC that costs $7,650 after tax to service annually and a $304k portfolio (that would be worth about $265k if cashed out all at once).
If, however, your MTR is lower when you cash out (e.g. < 30%), then the advantage swings to the RRSP investment – especially if you can get rid of the HELOC quickly.
The basic conclusion is that the higher your MTR AND the larger the difference between the cost of the mortgage/HELOC and your investment growth rate, the better it looks for the RRSP.
All in all, I don’t see sufficient evidence to suggest that the SM-RRSP hybrid can be reasonably be expected to outperform a traditional SM as long as tax efficient investing is used for the traditional SM. That is based on these facts:
- At the end, the SM has a HELOC that tax deductible interest payments where the SM-RRSP hybrid has no tax benefit.
- The RRSP will have significant tax consequences as one withdraws funds from it. The SM’s non-registered portfolio, although smaller, will have substantially less tax liability on withdrawals.
- A >4% difference between the long term mortgage rate and investment performance over 25 years is uncommon (unknown?) in Canada.
Thanks to Cannon_Fodder for taking the time to run the newest scenario. Cannon_Fodder has created a new commercial version of his SM Calculator that is more detailed. Contact me if you’re interested in learning more.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).