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:
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.
RRSP loan = $5k x 0.40/ (1-0.40) = $3333
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.
To further reduce interest costs, consider a 12 month, 0% interest credit card as your RRSP loan. Basically
- Apply for the card;
- Write a credit card cheque to yourself;
- Deposit funds into your RRSP account close to the RRSP deadline;
- File your taxes as early as possible; and,
- Use tax refund to pay back the credit card.
Cue geek jokes…
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