A sizeable number of financial strategies are fairly basic: Don’t spend more than you earn, reduce credit card debt, that sort of thing.
But you’ll need to get out the calculator to figure whether to maximize your contribution in an RRSP if you don’t have enough available cash.
That’s because the decision to borrow money to augment your long-term savings program depends upon a whole host of factors: Your tax rate, the size of the generated deduction, and the loan’s repayment period among others.
Still, this financial manoeuvre can be worthwhile if you think through the possibilities.
Canada’s RRSP program goes back decades and is designed to give people an incentive to save for their retirement and avoid relying too heavily on the Canada Pension Plan and other government assistance.
The savings program lets individuals shove cash into an investment account. This contribution generates a deduction in that year which reduces your tax bill. And the gains from your investments—dividends, interest and the like—accumulate tax-free.
The downside of the RRSP is that you are taxed when you take cash out, assumed to be after you stop working. The Canada Revenue Agency (CRA) gets its share but at the end of the savings process.
For an RRSP, the financial debate becomes whether you are likely to face a higher tax rate now when you’re working or later when you’ve retired.
Staring at the (RRSP) ceiling
An added layer of complexity occurs when a contributor doesn’t have enough cash on hand to meet their annual RRSP ceiling. At this point, do you get more money to put into your savings plan or do you let your RRSP contribution room accumulate?
First of all, there’s nothing wrong with letting your savings room collect; after all, Ottawa lets you hoard any leftover contribution space until you turn 71.
Say, for the previous decade, you have $7,500 of eligible room but can only use up $5,000 a year. In year 11, you will have the ability to contribute $32,500 to your RRSP ($7,500 annual room plus 10 years x $2,500).
So, why not just let your room accumulate? Because eventually, the aggregated amount becomes too large for you to ever use up.
Take someone making $45,000 now, who will see their earnings rise 3% a year for the next two decades. If that person accumulates $2,500 of RRSP room annually, by the end of the 20-year period, they will have a salary of $81,275 with available contribution space of $50,000 (20 years x $2,500).
The salary earner is unlikely to save enough over their remaining working life to ever use up the $50,000 plus any additional accumulated contribution room.
As an alternative, you could look to the bank to help you out by way of an RRSP loan. Here, however, the break-even math gets trickier. The basic idea is to borrow money to top up your RRSP savings for that year. But:
1. Make sure the interest rate on the loan is less than the annual rate of return on your RRSP. If it isn’t, you’re losing more in interest payments than you are gaining in extra investment return.
2. Alternatively, look for a loan amount that you can pay off within that year.
The second strategy has a number of moving parts in order to be financially viable.
One option is to borrow enough cash so that the tax deduction generated by your RRSP contribution matches the size of the loan.
For example, suppose you can only save $3,000 towards your total RRSP contribution limit of $5,000. Then you could borrow the $2,000 from the bank to match your savings ceiling. That move would generate a $2,000 tax deduction (assuming a 40% tax rate). Basically, you will be using your tax refund to repay the loan.
The advantage is that you now have $5,000—not $3,000—in your RRSP account accumulating tax-free investment returns.
Read:RRSPs Vs. TFSAs
If you have tons of unused RRSP room, you could borrow some percentage of that amount from the bank in order to catch up on your contributions.
You will have to watch the rate on your loan, however, since you’re now going to need more than 12 months to pay it off. Again, if the borrowing rate is too high, you’ll pay more in interest charges than you will gain in investment income.
But experts note there is a subtle benefit to this strategy. Under this scenario, you have already borrowed to add money to your RRSP. So, you can’t delay yearly contributions because you have converted your RRSP room into a loan that has a repayment schedule.
Effectively, you have forced yourself to make an annual RRSP contribution over the lifetime of the loan.
You also can max out your RRSP contribution and lower your taxes by using your TFSA.
The TFSA is a type of savings vehicle that, similar to the RRSP, allows you to accumulate returns on a tax-free basis over a person’s lifetime. The money deposited into a TFSA was taxed before it went into the account and it isn’t taxed when you make a withdrawal. On the other hand, your RRSP withdrawal is taxed.
Suppose you’re just starting out in the working world and not making much money.
Assuming you can’t hit your RRSP contribution ceiling, you could put the same dollars into a TFSA. Years later, when you’re earning more money and in a higher tax bracket, you then shift the principal and accumulated returns from the TFSA into your RRSP.
The advantage? The RRSP contribution generates a tax deduction that you can use against your higher taxable income and save you tax dollars.
These strategies are a sophisticated way of increasing your RRSP savings and reducing the CRA’s take. But, you have to be careful: The more complicated the game plan, the greater the risk that something could go wrong.