Many people don’t max out their RRSP contribution room in any given year. This can be for a variety of reasons. Perhaps they have too many expenses or perhaps they’re just not very good at saving money. Whatever the case, some of their RRSP room remains unused. Making an RRSP contribution allows you to claim a tax deduction and helps you save for retirement in a tax-sheltered manner.
A popular way to maximize RRSP contribution room when you don’t have the funds on hand is to borrow the money instead. It’s not an ideal strategy for every individual. However, you should make sure it’s appropriate in your case before getting a loan.
RRSP loan options
Most financial institutions typically offer two types of RRSP loans. A regular RRSP loan must be paid back within one year. You can often defer payments for up to 120 days but interest will continue to accrue. The other loan type is called an RRSP catch-up loan, which you can use if you have a lot of unused contribution room. You can usually borrow up to $50,000 and the loan term is typically up to five or 10 years. Keep in mind that long-term loans often have a higher interest rate.
When it makes sense to borrow
As a general rule, it makes sense to borrow in order to contribute to your RRSP if the financial benefits outweigh the costs. There are two benefits to getting a loan. First, by making the higher contribution, you’ll receive a tax deduction and quite possibly a tax refund. You may even be able to pay off a large portion of the loan with the refund. Second, by maximizing your contribution room, you’re saving for retirement. If your rate of return is high enough, it may also exceed the cost of the loan.
When it doesn't make sense to borrow
Conversely, it doesn’t make sense to borrow if in doing so the costs will outweigh the benefits. Experts suggest a few scenarios where this might be the case:
- You’re in a low tax bracket - If you’re in a lower tax bracket, it might not make sense to contribute to an RRSP even if you have contribution room.
- Interest rates are high — The interest rate you pay to borrow for your loan is a big factor in whether the strategy is profitable. The higher the interest rate, the less likely it is that it’s worth it to borrow.
- You already have debt - If you already have a high debt load or high-interest credit card debt, you may not be able to afford to borrow for your RRSP contribution. If you do get a loan, make sure you’re able to make all your regular debt payments.
RRSP loan strategies
There are numerous strategies when it comes to borrowing to contribute for your RRSP. One strategy is to “gross up” your contribution.
For example, say you live in Saskatchewan and your marginal tax rate is 39%. You already plan on contributing $6,000 to your RRSP and want to borrow $4,000. Your total contribution of $10,000 should result in a tax refund of $3,900, which you can use to pay off your loan. As a result, you’ll add an additional $4,000 to your RRSP and your loan will be paid off almost immediately.
Another strategy is to “top up” your contribution. If you have just $1,000 to contribute, you can get a one-year loan of $5,000 and make a total contribution of $6,000. If your marginal tax rate is 39%, you should get a tax refund of $2,340. You can then use the proceeds to help pay off the loan more quickly.
And there’s also the “catch up” strategy. Most Canadians have unused RRSP contribution room and many financial institutions offer catch-up loans. Let’s say you have $25,000 in unused room available and have a marginal tax rate of 39%. If you get a catch-up loan and contribute $25,000 to your RRSP, you should have a tax refund of $9,750. By using the proceeds to pay off part of the loan, you’ll reduce what you owe to $15,250.
Before getting an RRSP loan, you should weigh the pros and cons and decide what approach works best for you.