Loans are a part of life for most Canadians. We take out loans to pay for our cars and our homes, for vacations, furniture, even TVs. And at this time of year, as the deadline for making your 2010 Registered Retirement Savings Plan (RRSP) contribution looms, you may be asking yourself if it makes sense to take on one more loan – a loan to increase your RRSP contribution. Let’s find out.
When (and why) it makes sense to borrow
Whether it makes sense to take on another loan - to increase your RRSP contribution - depends on the overall shape of your financial life. Let's look at the factors you should consider:
- Because contributing to your RRSP can pay off in two ways. First, you'll increase the size of your tax refund; second, you'll have more tax-deferred money growing inside your retirement plan. But the first rule is this: The loan must fit your budget.
- When you intend to pay off the loan within a year. Remember, interest on an RRSP loan is not tax-deductible. Consider a series of smaller RRSP loans with payments within your budget. Longer term loans are more suitable for purchasing non-registered investments (wherein the interest is tax deductible).
- When the size of the loan maximizes your tax savings. Tax rates rise with income. More tax can often be saved by spreading RRSP deductions over more than one year. While contributions made in one year can be deducted in a future year, it does not always make sense to borrow to make an RRSP contribution if it will take several years to fully utilize the deduction. Again, a series of smaller loans may produce the better financial result.
- When you use your tax refund to pay off the loan as quickly as possible.
Or maybe not
- If you expect to be taxed at, or near, the lowest marginal rate over time. In that case, you won't get the full tax-reduction benefit of making your maximum RRSP contribution, so the cost of taking out an RRSP loan doesn't make sense. Instead, you might want to consider contributing to a Tax-free Savings Account (TFSA). The contribution isn't tax deductible, but money and interest inside a TFSA are tax-free and unlike your RRSP, so are withdrawals, which can be made at any time for any purpose.
- If your increased RRSP refund is already earmarked, in whole or in part, to pay taxes you owe on other income.
- If you are unsure whether your income level will allow you to meet your RRSP loan obligations, which you will be required to do regardless of your income level and the performance of your RRSP in the shorter term.
Borrowing to increase your RRSP contribution can be a useful strategy, but it also comes with specific risks. To lessen the risk, you might consider avoiding the need to borrow next year through a Pre-Authorized Contribution plan (PAC) that automatically deducts and saves any amount you want from your regular paycheques.
Your professional advisor can help you map out the RRSP contribution strategy that fits the overall shape of your financial life. Remember, it's about balancing the present with the future. You have to find a compromise that works for both.
This article is published by Millie Gormely, CFP, EPC, Financial Consultant with I.G. Insurance Services Inc. as a general source of information only. It is not intended to provide personalized tax, legal or investment advice, and is not intended as a solicitation to purchase securities. Millie Gormely is solely responsible for its content.