Making the decision to borrow for RRSPs
According to many surveys, Canadians feel they will not have enough money for retirement. Some studies suggest that as much as 73% of Canadians worry about not having enough money saved to live in their retirement.
Last year, Canadians put away $27.6 billion into RRSPs, up 2% from the year before. While that may sound impressive, you may be surprised to know that that only represents 9% of all the RRSP room available to Canadians. In other words, there is still a lot of Canadians that are not utilizing one of the best tax savings vehicles available to them.
With so much unused RRSP contribution room, should Canadians go out and borrow to buy RRSPs? With interest rates still at low levels, does this make it the right time to catch up on RRSPs with RRSP loans? It’s a multi-billion dollar question that needs a more detailed discussion.
The simple calculation
If you borrow $10,000 to buy your RRSP, it will cost you about $270 in interest over the course of a year (at 5%). Even though you cannot deduct the interest on loans for RRSP contributions, this is a relatively small price to pay considering the tax benefit you will get. Depending on your marginal tax rate, you are likely to get somewhere between $2300 to $4900 in tax savings. Add in the tax-deferred growth inside the RRSP and you’ve got a pretty solid investment.
What rate can you expect on a RRSP loan?
Every institution is different. The bottom line is just like you would shop around for mortgage rates or GIC rates, you can shop and negotiate for RRSP loan rates. In most instances, you can borrow at prime, which is currently 4.25%. In some cases financial institutions are offering incentives during RRSP season at rates below prime.
In most cases, RRSP loans are straight forward 1-year loans. If you deviate or try to extend the term, typically the rates will go up.
Does it make sense to borrow on lines of credit for the RRSP?
The main difference is that a line of credit is more flexible and you do not have to pay off the loan within one year.
Does it make sense to extend the term of the loan for longer than 1 year?
If you extend the term for longer than a year, the biggest advantage is your payments are a lot smaller. The bad news, however, is you will pay more interest over the longer term. In the same example as above, the payments on a $10,000 RRSP loan at 5% for 1 year would be $855.84 per month. If you spread that out over 2 years, your payments would drop to $438.48 per month but the total cost of interest goes up to $524 instead of $270. The benefit of the tax deduction still out weighs the cost of the loan. If you extend the loan to 5 years, you wind up paying about $1300 in interest and borrowing is less attractive.
Does it make sense to borrow larger amounts if you have unused RRSP contribution room?
As an example, I have a client Jack who has $30,000 of unused RRSP contribution room. His income is $85,000 per year. If we contributed the entire $30,000 of unused RRSP contribution room, he would get a tax deduction of about $10,200 (Based on Alberta Tax Rates). However, rather than make the entire contribution today, he may use some this year and some next year. Why would he do that? The tax bracket cut-off is $70,000. Thus, he will get the maximum deduction if he uses $15,000 this year to bring his $85,000 income down to $70,000. Then do the same thing next year. In Alberta, this strategy would get him a tax savings of $10,800 instead of $10,200 (that’s an extra 5% on his money). The key is to know the marginal tax rates that apply. Each Province is different.
The other advantage of splitting the contribution is it makes it more affordable to borrow $15,000 now than $30,000. The payments on a $30,000 loan would be almost $2600 per month. That’s a lot of money!
Is the interest on RRSP loans tax deductible?
At one time you could deduct the interest on loans made for buying RRSPs. Unfortunately, the government closed that deduction a long time ago. Today, you cannot deduct the interest on RRSP loans.
So there you have some common questions and answers to help you make the right decision for borrowing to buy RRSPs this year. Good Luck.