January 14, 2011

Boost Your RRSP Contribution With a Short-Term Loan

If you are not able to contribute sufficiently, is borrowing to invest in your RRSP a good strategy?

Repay your short-term RRSP loan with your tax refund

A short-term loan is usually a brilliant idea; you can make a larger contribution to your retirement plan while limiting interest charges.

Towards the end of RRSP season (in February), you can borrow and contribute. You have to make sure to FULLY repay your RRSP loan a few months later when you get your tax refund (in March, April or at worst in May).

This short-term strategy allows you to increase your RRSP contribution without paying too much interest.

Forget long-term RRSP loans

On the other hand, think twice before borrowing for a longer period. The main reason you should avoid long-term RRSP loans is interest charges. They will quickly add up and are not tax deductible when used to contribute to a registered plan.

Financial institutions and their salespeople often promote loans to maximize your RRSP. Even a so-called generous tax refund cannot justify undue interest charges and getting into costly loan payments.

It might be better to start an automatic RRSP savings plan to deduct on next year’s taxes or to pay off some other debt. Regular RRSP contributions are preferable because RRSP deductions are more beneficial in higher tax-bracket.

How much should you contribute short-term?

Knowing the available amount you can contribute to your RRSP without borrowing, it’s possible to calculate how much you can afford to borrow on a short-term basis for your RRSP loan.

While a more detailed tax simulation is recommended, it’s relatively simple to estimate the total RRSP contribution you can make using a short-term RRSP loan by applying the following formula:

Total RRSP contribution =
RRSP contribution without loan /
(1 - Marginal tax rate)

Indirectly, this formula also gives you the short-term RRSP loan amount.

Example 1

 - Possible RRSP contribution without loan: $1500
 - Marginal tax rate: 40%

Total RRSP contribution =
$1500 / (1 – 40%) = $1500 / 60% = $2500

Short-term RRSP loan amount =
Total RRSP contribution - RRSP contribution without loan =
$2500 - $1500 = $1000

So if you only have $1500 at your disposal, you could still contribute $2500 to your RRSP by borrowing $1000.

Your $2500 RRSP contribution will allow you to receive an extra tax refund of $1000 that you will use to completely repay your short-term loan.

Use your anticipated tax refund to contribute even more

If you anticipate that you will get a tax refund without contributing to your RRSP, it may be a good idea to add that anticipated return to contribute even more. Let’s factor in a $600 anticipated tax return and redo the math.

Example 2

 - Possible RRSP contribution without loan: $1500
 - Marginal tax rate: 40%
 - Anticipated tax return without RRSP contribution: $600

Total RRSP contribution =
($1500 + $600) / (1 – 40%) = $2100 / 60% = $3500

Short-term RRSP loan amount =
Total RRSP contribution - RRSP contribution without loan =
$3500 - $1500 = $2000

Now you could contribute $3500 to your RRSP!

You would borrow $2000 and fully repaid that short-term loan with your tax return
[Anticipated tax return without RRSP + RRSP tax return =
($3500 x 40%) + $600 = $1400 + $600 = $2000].

Of course, you will also have to assume minimal interest charges for that short-term RRSP loan (Max of about $35 @ 7% for 3 months).


Regardless of the strategy, be sure it’s well suited for your whole financial situation and especially that it enables you to achieve your retirement goals.

To resume, short-term RSSP loans can boost up your RRSP at a relatively low cost. Accumulating interest charges on medium to long term loans make them less interesting.

So, despite what your commission-paid investment adviser can tell you, smaller and shorter RRSP loans every year are probably a better alternative than one big RRSP loan over a couple of years.

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