Borrowing to Contribute to your Retirement Plan

Carol Waldmann, Investment Executive, ScotiaMcLeod

Many of my clients ask if they should borrow to invest in their Registered Retirement Savings Plan (RRSPs). This is not an easy question as it depends on your personal financial situation – how much debt do you already have? How far away is retirement for you? When can you afford to pay it back? And most importantly – how disciplined are you? Here is the conversation that I have with my clients – I hope you find it valuable.

Short Term Option

The general rule of thumb is that as long as you can pay back your RRSP loan within the year, you are better off than if you do not make the contribution at all. For example, if you borrow $10,000 at 5%, your monthly payment would be $856 and your total principal and interest payments for the year would be $10,273. If your RRSP grew at 8%, the total value of the contribution after one year would be $10,800.

After one year, you are already ahead by $527. Where it really begins to make sense is when you use your tax refund to pay down your loan. Let’s assume that you are in the 40% tax bracket, this $10,000 RRSP contribution may result in a good-sized tax refund. Be disciplined with your tax refund and use it to pay down your loan.

Long Term Option

What happens if you are unable to pay back your RRSP loan within the year? This may be the case if you have large amounts of unused RRSP room.
For example, what if you had $50,000 in unused room and were able to get a 5% loan for 5 years starting January 1, 2008, your monthly payments for the first six months would be roughly $950.

At the risk of sounding like a broken record, use your tax refund from the contribution to pay down your loan. Once you have reduced your outstanding loan by applying the tax refund you have two choices, you can either continue to pay $950 a month, which would result in you paying off your loan early. Or, you can keep your 5-year term and reduce your loan payment to $470. Assuming an 8% rate of return in your RRSP, within 5 years the $50,000 contribution will be worth $73,466 and within 25 years it will be worth $340,000!

Remember – RRSP Loans Are Not Tax Deductible
The interest on a loan for your RRSP is not tax deductible!

The Bottom Line

If the only way you are able to contribute to your RRSP this year is to take out a loan it may be a good idea. However, the longer the loan is outstanding the more non-deductible interest you will end up paying so if you choose to borrow ensure that you understand the long-term implications of your decision. When in doubt, talk to an investment advisor. Be safe and prosper!