Borrowing now can pay big-time later True, getting a loan means going into debt. But it can reduce your taxes and put you ahead in the long run, JEFF BUCKSTEIN writes
When she found herself a bit shy of funds to contribute to her retirement savings plan for 2006, Sarah Appleton talked to her financial adviser and decided on a tried-and-true strategy to bridge the gap.
The Ajax, Ont., resident took out a $3,000 RRSP loan from the Canadian Imperial Bank of Commerce. The loan served two purposes, explains Ms. Appleton, who was working in the financial services industry at the time but is now attending college full-time.
“It’s helping me plan for my future — plus, the money I get back from my taxes can be used as tuition at school,” says Ms. Appleton, who is studying to become a paralegal and law clerk.
Financial experts have long touted the benefits of making the maximum allowable contribution to your RRSP every year, noting the unique and significant tax-deferred financial gains it presents for retirement.
Ideally an investor “sets aside a sum of money on a continuous purchase program to buy an RRSP and doesn’t have to get into ..... borrowing,” says Cherith Cayford, director of CMG Financial Education in Victoria.
But she also realizes there are times when this is not possible or practical, adding that “we don’t live in an ideal world.”
If you’re short of funds, a key strategy to make the most of your allowable contribution is the RRSP loan, which can be a fruitful strategy.
Say, for example, a taxpayer in the 40-per-cent tax bracket borrows $10,000 to put into an RRSP. Thanks to compounding interest, that money can grow substantially over the years on a tax-deferred basis (and when the money is withdrawn years later, the person will probably be in a lower tax bracket). The loan also offers immediate benefits because the current tax bill would be reduced by $4,000 (40 per cent of $10,000). And if that $4,000 RRSP contribution results in a tax refund, it can be used immediately to pay down a significant portion of the loan.
The timing of an RRSP loan can make good economic sense, according to Jim Yager, a partner in the international executive services area of KPMG LLP in Toronto.
“You want to be able to take advantage of the deduction when you’re in the highest tax bracket,” he says, so a smart strategy for an investor in a high tax bracket could be to borrow, make the RRSP contribution and be eligible for the tax refund.
Interest rates for an RRSP loan are usually quite favourable, and are often negotiable for long-standing customers. Financial institutions generally provide competitive rates at or near prime, as well as a grace period whereby customers don’t need to make any payments until a later date.
At TD Financial Group, for instance, where variable RRSP loan rates are set at prime and most fixed rates are either at or very close to prime (depending on the repayment period), customers don’t have to make their first payment until 120 days after the loan is made, although interest will accrue during that period. This gives people the opportunity to pay down all or part of the loan with the proceeds from their tax refund, says Patricia Lovett-Reid, senior vice-president of TD Waterhouse Inc. in Toronto.
Experts warn, however, that for the RRSP loan strategy to be effective, most individuals should generally pay off their loan quickly — ideally, within one year.
Ms. Appleton negotiated her 2006 loan rate at prime, to be paid over a one-year period, and she is currently ahead of schedule.
Consumers should also avoid the temptation to borrow too much, warns Ms. Cayford. “At this time of year many financial institutions are encouraging people to catch up on all their back RRSP [contribution room],” says Ms. Cayford, who is not in favour of investors borrowing a large amount — say in the range of $50,000 or $60,000 — to do this.
“I’m in favour of making it manageable,” she stresses, adding that “any borrowing comes down to capacity,” meaning that borrowers need to ask themselves whether they can afford to make the payment on that loan.
Borrowers also need to weigh the tax implications of deducting large RRSP amounts all at once, because doing so could push them into a much lower tax bracket, meaning their tax savings are minimized. In fact, it is not necessary to deduct the full amount of an RRSP contribution in one year; instead, it can be spread over several years in a way that is most tax advantageous.
Of course, there are drawbacks to taking out a loan for an RRSP. The key one is that the interest payable on the loan is not deductible (because the loan is for personal, rather than business, purposes).
Another disadvantage is that an RRSP loan, by definition, means you’re taking on debt — something many people would rather avoid.
Investors who have other sources of funds, such as “money sitting in something like a GIC,” might instead use the cash proceeds from that for their RRSP contribution, suggests Janice Paul, a Toronto-based certified general accountant.
A variety of instruments can be transferred into an RRSP in lieu of cash, including publicly traded stocks and bonds, Canada Savings Bonds and guaranteed investment certificates, among other things. Investors should check with a financial professional if they are unsure about what is eligible for transfer into their RRSP. (They should also be wary of unscrupulous promoters pushing bogus products they say can be invested directly into an RRSP, warns Ms. Paul.)
Experts note there are a couple of caveats when transferring equities into an RRSP. First, the stock will be deemed to have been sold, meaning that if it has increased in value, a capital gain will result (although at a favourable rate, with only half the gain being taxable). And if the stock has lost value, the investor cannot realize a capital loss, which could otherwise reduce taxes.
Second, once equities are transferred into the RRSP any future gains or losses will be treated as regular income and be taxed accordingly, instead of receiving the preferential capital gains or losses tax treatment it would otherwise attract outside the RRSP. So, says Ms. Lovett-Reid, “you want to be very selective about what you’re putting in the plan.”