5

While evaluating a short term RRSP loan like this one, the numbers seem good on paper. But:

If I need to save $1,000 in tax deductions, I need to put the entire borrowed money into the RRSP before I start making any loan payments. But the loan payments begin as soon as I take the loan – so basically each monthly payment for $220.00 comes from my savings.

I gather that the savings shown at the end is to be taken with a grain of salt. If I just took those payments for $220, saved it over a year and put it in the RRSP, then the savings would be 40% of $2,640 = $1,056, which is much greater than $860. So it seems to me that this kind of loan is never a good idea?

Am I missing something? Maybe if the interest on the loan were tax deductible, then it might make sense, but I don't think that is the case here.

7

My opinion is that in general, it is probably not a good idea to borrow at a cost in order to make your RRSP contribution. Banks, of course, have an interest in loaning you money. Don't expect their literature to be objective on the matter! They are selling you a product and the advice is biased. What better way to double-dip than to get guaranteed interest payments from you, as well as ongoing fees for (probably also) getting your loan money invested in their high-fee mutual funds?

A year's RRSP contribution room allowance isn't use it or lose itunlike 401k contribution allowances in the U.S.. That is, unused RRSP contribution room accumulates and you can take advantage of it in later years. If we couldn't carry our RRSP contribution room over, I might feel different about the general case for RRSP loans.

Yet there are two specific cases I can think of where it may make sense to borrow and pay back:

  • (a possible case) ... if your tax rate is currently in a high bracket (e.g. 46%), and you anticipate being in a lower income and bracket next year (e.g. 35%), then it would make sense to take advantage of the higher tax savings in the current tax year. If you waited until the following year to take the deduction, you'd lose out on 11% of the deducted amount.

    For a typical person whose income is level or increasing from year to year, this isn't likely to be applicable, but it could help somebody who is going on leave or otherwise has irregular income.

  • (a foolish case) ... if you knew, somehow, that you could realize a return on your invested RRSP money exceeding the pre-tax earnings required to pay the interest on the RRSP loan. However, I would suggest this is foolish bet to make. The interest you pay is guaranteed, but the return you are expected to get is probably not (or if it is, it is probably a return lower than what your bank wants to charge on the loan.)

If for some reason it does make sense for you, take the money and invest it somewhere better than the high-fee mutual funds the bank is also pushing.

  • Thanks. But what baout the case where interest charged on a loan for investment is tax deductible?So if i take the loan, put in rrsp and invest in stocks, i get an additional refund right? is thsi a possible case? – Victor123 Jun 6 '13 at 20:02
  • RRSP loan interest isn't tax deductible, even if you invest the loan proceeds into income-producing investments within your RRSP. To get a tax deduction on your loan interest, you would need to invest the proceeds of a loan (not an RRSP loan) inside a regular taxable investment account. – Chris W. Rea Jun 6 '13 at 20:04
4

There are some circumstances in which it is a good idea. Chris W Rea has already mentioned the case where you expect your marginal tax rate to decrease. But there is also the case where lack of contributions might cause your marginal rate to increase.

Assume your income is $20,000 over the 46% threshold, and you normally contribute $20,000 to RRSP. However this year you have only been able to contribute $10,000. If you wait until next year and contribute an extra $10,000 (making $30,000) the extra $10,000 will only bring 35% tax back. If you can borrow the money and make the contribution this year it will get 46% tax back. That makes the loan worth taking.

Making the contribution now can also get you a larger rebate this year. You will have that money for twelve extra months and you can invest it. That probably isn't enough to make it worthwhile alone, but it certainly makes the damage less.

However I would always recommend taking out an RRSP loan for as short a time as possible. My recommendation would always be to make the contribution as late in the period as possible, apply for your tax refund as soon as you can, and then pay off the loan with the refund. You shoulod be able to get away with having the loan only for a couple of months.

  • +1. Yup, much better to spread out your contributions at higher brackets each year than pouring it all in at once and driving your average % deducted down. – Chris W. Rea Jun 7 '13 at 14:30
  • Thnaks DJ. As for your 1st point, are you suggesting it makes sense to take the loan if by taking the loan and contributing the amount to rrsp, you end up in a lower tax bracket? – Victor123 Jun 7 '13 at 17:13
  • More or less. It's not quite that simple. The same logic would apply if you were $20,100 above the tax threshold, in which case making the contribution this year doesn't actually drop your tax bracket. But the point is that this year the contribution comes out of your 'high tax bracket' income. If you contributed it next year it would come out of your low tax bracket income. – DJClayworth Jun 7 '13 at 17:19

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