The scoop on RRSP loans
Borrowing to make your maximum RRSP contribution is one of those times, provided these conditions are met:
1. You don’t have adequate cash available and have no securities that you can use to make a contribution in kind.
2. You can repay the loan within one year.
3. Using the carry-forward provision would not be to your advantage.
If all these conditions apply, borrowing for an RRSP is an excellent financial strategy. Here’s an example to illustrate why:
Suppose you’re entitled to make a maximum RRSP contribution of $5,000 for the 2002 tax year but you’ve only saved $2,000. The contribution deadline is looming and you’re debating whether to contribute just $2,000 or to borrow an extra $3,000, which will allow you to make the maximum $5,000 deductible contribution. Let’s assume your marginal tax rate is 40 percent, that you can invest the money in your RRSP at 5 percent, and that the loan is repayable in 12 monthly instalments at an interest rate of 6.5 percent (RRSP loans are offered at prime rate or close to it).
Here’s how the alternatives shape up:
|Contribution||Contribution (with loan)|
|Tax refund @ 40%||$800||$2,000|
|Interest for one year @ 5%||100||250|
|Less cost of loan @ 6.5%||0||(107)|
As you can see, your net gain in one year is more than twice as much by borrowing the $3,000. And this assumes you make no pre-payment against the principal over the year. If you use your $2,000 tax refund to pay it down as soon as the money arrives, your actual borrowing costs will be much less.
No matter what tax bracket you’re in, the one-year return from borrowing for your RRSP will be greater than if you fail to make your full contribution, assuming you borrow the money at commercial rates. The higher your tax bracket, the greater the advantage of using this strategy. Just remember, the loan must be repaid within a year. In the second year, the costs of carrying the loan will be higher than the interest the money earns inside the RRSP and there are no more offsetting tax deductions.
Obviously, you’re better off making your full RRSP contribution from existing savings. But if that’s not feasible, you should give serious consideration to applying for a loan.
Adapted from Gordon Pape’s 2001 Buyer’s Guide to RRSPs, published by Prentice Hall Canada.