Hey there, time traveller! This article was published 16/2/2019 (620 days ago), so information in it may no longer be current.
Cabin fever aside, February brings with it feverish financial industry pitches to make last-minute contributions to your RRSP.
Amidst the usual marketing mantra to make a lump-sum contribution to reduce your taxes for 2018 before the March 1 deadline, you might also hear about RRSP loans.
If you’re unfamiliar with the concept, here’s how the RRSP loan works. Take out a loan and use that money to contribute to your RRSP before the deadline. Come spring, after filing your taxes, you get a refund and use that money to help repay the loan.
Then you make monthly payments and close out the loan, preferably within the year.
And, maybe, you do it all over again next year.
If this sounds a bit risky, it can be. But it also can work well for certain individuals. Typically these are folks who are behind on retirement saving and need a forced savings plan to quickly build up their RRSP.
"Usually, loan strategies are used by people who have compiled a fair bit of RRSP contribution room and want to catch up," says Todd Sigurdson, director of tax and estate planning at IG Wealth Management.
What’s more is these individuals usually have good, steady incomes and don’t have a great pension plan (i.e. defined benefit).
So just how much contribution room might that be? At least $20,000, he says.
It’s likely a lot of Canadians fit that description, says wealth adviser Cory Papineau with the Winnipeg Police Credit Union. After all, we collectively have half a trillion dollars of unused RRSP contribution room, he points out.
"Many Canadians are not saving nearly enough for retirement," the certified financial planner says.
Consequently, "RRSP loans can be a very powerful tool to help Canadians boost their retirement nest eggs and take advantage of tax deferral opportunities and compound interest."
The strategy is often suited best for individuals ages 35 to 50 earning more than $75,000 a year before taxes in Manitoba. The reason is that RRSP contributions must make sense from a tax-planning perspective in the first place — loan or no loan. Individuals earning $75,000 in Manitoba pay a marginal rate of 37.9 per cent on income above about $69,000. So an RRSP contribution today results in that much tax savings, often reflected in the refund come spring. Additionally, it’s unlikely the contributed money will then be withdrawn in retirement at a higher rate. Rather, it’s more likely you will pay tax at a lesser rate, resulting in true savings.
So if these numbers make sense for your situation and you need to catch up, a loan is worth considering. But Sigurdson cautions the RRSP loan strategy only has merit if you are disciplined enough to repay the loan.
This means when you get that refund in May, the money must go toward repaying the loan. And then you must continue making regular monthly payments to close out the loan.
"You have to be committed to paying the loan off in a fairly short time — about two years or less," he says.
Understandably, the RRSP loan is not a good strategy for someone with a lot of credit-card debt. It’s much better to focus on getting rid of that financial albatross first.
Even those for whom the loan math appears to make sense should still approach the concept with some skepticism, the head of one of Canada’s leading robo-advisory firms says.
"There’s a lot of these theoretically good, mathematically sound strategies that people can use to squeeze an extra dollar into their savings," says Tea Nicola, CEO and co-founder of Vancouver-based WealthBar Financial Services.
"But then emotions get involved; people can’t remain disciplined, and in the long run it hurts them."
So while the RRSP loan can work well in theory, reality may dictate otherwise — especially in our current market and economic environment.
We’re at the top of the long, long bull market, so the risk of a nasty pullback in prices — and an economic recession along with it — is more elevated than at any point in the last decade. We’re also in a rising interest-rate environment, so loans with variable interest rates — often the case with RRSP loans — are likely to cost more in the near future.
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These conditions increase the likelihood that "you could find yourself in a position where the principal of the (RRSP) loan is higher than the value of the investment account," Nicola says.
And this especially stings because you’re not just experiencing the bitterness of being down on your initial investment. You have to make those loan payments, too.
So yes, individuals with steely intestinal constitutions and a firm grasp of the mechanics of an RRSP loan can end up with a larger retirement kitty than if they were only making regular monthly contributions without a loan.
But the question everyone should ask is, "How sensible will this strategy feel if markets take a nosedive?"
As Nicola argues, despite what we tell ourselves to the contrary, most of us aren’t built to be rational when terror strikes the markets.
"As soon as emotions get involved, the most mathematically sound strategies tend to not turn out as expected."
The math behind the RRSP loan
Let’s say you earn $80,000 a year before taxes. So any RRSP contribution will result in a refund of about 38 per cent (the marginal tax rate is 37.9 per cent in Manitoba) of your money in the spring.
Now an RRSP loan might be a good strategy in this case if, for example, you have already been contributing $420 a month for a total of $5,000 in contributions for 2018.
That’s money saved before the loan this month. Then you borrow $5,000 more, which brings the total contribution to $10,000 for 2018. This sum results in a $3,790 refund. If you use that money to repay the $5,000 loan, you’re left owing $1,210, and then you need only pay about $100 a month to pay the loan off in one year.
Financial planner Cory Papineau argues this monthly sum is roughly less than a family’s mobile phone or cable bill every month. But “remember, after paying your cellphone bill each month for the next 25 or 30 years, Bell or Rogers will not be throwing you a party, but with your nest egg by paying yourself first, you can throw your own (retirement) celebration.”