When it makes sense to borrow for your RRSP

Q: I have no pension plan at work, and need to increase the savings in my RRSP. I do a small monthly RRSP savings, but always end up short at the RRSP deadline. Is it worth doing an RRSP loan?
A: Loans are a part of life for most Canadians. We take out loans to pay for our cars and our homes, for vacations, furniture and TVs. As the deadline for making your 2012 Registered Retirement Savings Plan (RRSP) contribution looms, you may be asking yourself if it makes sense to make one more loan… a loan to increase your RRSP contribution. The right answer for you depends on the overall shape of your financial life. Let’s look at the factors you should consider.

When does it make sense to borrow:

  • First of all, consider an RSP loan only when you can afford the loan payments.
  • By using an RSP loan strategy, you will benefit from 2 main advantages: First, you’ll increase the size of your tax refund; second, you’ll have more tax-deferred money growing within your retirement plan.
  • This strategy often works best when you intend to pay off the loan within a year. Remember: Interest on an RRSP loan is not tax-deductible. Consider a series of smaller RRSP loans with payments within your budget. Longer term loans are more suitable for purchasing non-registered investments (when the interest cost is tax deductible).
  • When the amount of the loan maximizes tax savings. Tax rates increase with income. More tax can often be saved by spreading RRSP deductions over more than one year. While contributions made in one year can be deducted in a future year, it does not always make sense to take out an RRSP loan if it will take several years to fully utilize the deduction. Again a series of smaller loans may produce the better financial result.
  • It is ideal when you can use your tax refund to pay off the loan as quickly as possible.

Or maybe not …

  • If you expect to be taxed at, or near, the lowest marginal rate over time. In that case, you won’t get the full tax-reduction benefit of making your maximum RRSP contribution, so the cost of taking out an RRSP loan doesn’t make sense. Instead, you may want to consider contributing to a Tax-free Savings Account (TFSA). The contribution isn’t tax deductible but money and interest inside a TFSA is tax-free and, unlike your RRSP, so are withdrawals, which can be made at any time for any purpose.
  • If your increased RRSP refund is already earmarked, in whole or in part, to pay taxes you owe on other income.
  •  If you are unsure your income level will allow you to meet your RRSP loan obligations, which you will be required to do regardless of your income level and the performance of your RRSP in the shorter term.

Borrowing to increase your RRSP contribution can be a useful strategy but it also comes with specific risks. Perhaps you can avoid the need to borrow next year through a Pre-Authorized
Contribution (PAC) plan that automatically deducts and saves any amount you want from your regular paycheques. A regular PAC becomes part of your budget as a monthly cash outflow that you probably won’t miss and removes the temptation to spend those available dollars for personal consumption. When markets decline, automatic contributions allow you to purchase more units when they are cheaper and fewer units when markets rise, resulting in a lower average cost over the long term. And, of course, there are many other good RRSP investment strategies. Your professional advisor can help you map out the RRSP contribution strategy that fits the overall shape of your financial life.