We’re already in February and that means every finance blog in Canada is talking about RRSP season. RRSP’s are a fantastically powerful investment vehicle, which is why banks tell you if you don’t have the money to contribute, it makes sense to take out an RRSP loan.
The pitch is pretty simple: You’ll get a tax refund on every dollar you contribute to your RRSP. So every dollar you borrow will not only contribute to your retirement savings, but you’ll also get a chunk of it back in cash!
There are a few problems with this strategy. First, this refund is based on your final tax rate, not your marginal tax rate. If you’re in a 40% tax bracket based on your salary, you have to remember that any contribution to your RRSP (plus any and all other deductions you have) reduces your taxable income. So if you contribute $5,000 to your RRSP during the year, you might be expecting a refund of $2,000 (40% of $5,000). But by contributing the $5,000, you are probably lowering yourself to a lower tax bracket (closer to 35% from 40%), meaning your return might end up being $1,750 (35% of $5,000).
Now that you understand the math, we have to ask if it makes sense to take out one of these loans.
The main point is that since you only receive a portion of the loan back with your refund, you’re still going to owe the balance. If you borrow $10,000 on an RRSP loan and end up receiving 35% of it back, you still owe the bank $6,500. The rest of your income tax return might cover a portion of that, but you’re still going into debt to invest.
Bank employees will tell you that investing more into your RRSP for the long-term will provide you with a better retirement, but they’ll conveniently gloss over the long-term costs of the loan you have to take out to get there. Using compound interest to build your retirement is great, but servicing a loan with compounding interest is definitely not in your best interest.
When It Makes Sense To Take Out An RRSP Loan
The only “safe” way to take out an RRSP loan is if the total return you’ll receive will pay back the entire loan.
Here’s a helpful formula you can use to calculate what this should be:
RRSP Loan = (Total RRSP Contribution x Tax Rate) / (1 – Tax Rate)
The tricky part is figuring out what your actual tax rate will be after your deductions. Here’s an example:
RRSP Loan = $10,000 x 0.35 / (1 – 0.35) = $5,385
This means if YOU contribute $10,000 to your RRSP and then take out a loan for $5,385, your tax refund should be that same $5,385 ($15,385 x 0.35), which you can use to pay back the loan immediately.
You’ll pay a small amount in interest, but you’re effectively getting $5,385 for free.
Again it’s absolutely crucial to know your final tax rate before running this calculation.
Later this week we’ll be talking about TFSA’s and what makes more sense for you to help reach your retirement goals.