Last week we talked about the benefits of an RRSP. I also mentioned that this may be the year to catch up on any unused contribution room. For many people, catching up on RRSP contributions will only be possible by taking out RRSP loans.
During the RRSP season, it will not be difficult to go into any financial institution or any financial advisor and get an RRSP loan at prime (7.5%). In my opinion, you must weigh two factors when considering that RRSP loan – the benefit and the cost.
We talked in great depth last week about the benefit of an RRSP. It is important that you understand your personal marginal tax rate to determine the benefit of contributing to an RRSP. In most cases, you want to contribute enough to an RRSP to bring you down to the next marginal tax bracket. For example, if Joe earns $34,000 per year, and has an unused RRSP contribution room of $10,000, he would maximize efficiency by contributing $4000 into his RRSP to bring his income from $34,000 to $30,000 which is the cut-off between the lowest marginal tax bracket and the middle income bracket. This would give Joe a 36.5% tax saving or in real dollar terms $1460 in tax savings.
Any additional deduction would result in a 25% tax saving. This is still good but saving the rest of the unused contribution room for 2001 would result in a 32% tax savings.
To complicate matters more, Joe might opt to borrow to contribute the entire $10,000 into an RRSP immediately but only choose to deduct the $4000 for the 2000 tax year. If his contribution was made in January or February of 2001 he can choose to apply the contribution to either 2000 or 2001. Thus, Joe would now be ahead of the game because he will have made his 2000 contribution and now he will have made his 2001 contribution at the beginning of the year instead of at the end of the year. Keep in mind that the government allows for a $2000 lifetime overcontribution limit. Joe could have borrowed up to $12,000 but only $10,000 would be available for a deduction and $2000 would be considered an overcontribution.
The next factor we must take into account is the cost of the loan. By most standards, we would consider the cost to be the interest paid on the loan. Most RRSP loans are for a 1-year period and they are open loans, which means you can pay them off at any time. For every $1000 borrowed at prime (7.5%) for a 12-month period, you will pay about $40 of interest. In the case of Joe, based on a $10,000 loan, he would be paying about $400 of interest over a 12-month period. If Joe took the tax refund ($1460) as a result of making the RRSP deduction and paid down the loan he would only pay about $335 of interest on the same $10,000 loan. It is important to note that the interest on RRSP loans is no longer tax deductible. The interest on the loan is a small price to pay considering the tax savings on the contribution.
However, it is probably more important to look at whether you can afford the monthly payments on the loan. Looking at the tax savings is great but you must be able to afford the monthly payments.
For every $1000 RRSP loan, over a 12-month period, you will need to pay back about $86.70 per month. In Joe's case, in order to borrow $10,000 he would have to be able to pay $867.05 per month. To alleviate some cashflow concerns, some institutions will allow you to extend your amortization of the loan beyond 12 months to 24 month for example. However, often extending the term of the loan will increase the interest rate and the total interest paid. Cashflow is a very important consideration when thinking about taking out that RRSP loan.
As I often mention, everybody's situation is unique. I have tried to give you some important considerations when taking out that RRSP loan. To summarize, look at your marginal tax rates, the rate on the loan, and the monthly payments. If you are not sure, about calculating these variables on your own, seek the help of a financial advisor.