Relatively-low interest rates make it cheap to borrow these days. If you can’t maximize contributions to your RRSP (Registered Retirement Savings Plan), consider borrowing to do so. In Hamlet, Polonius warns his son to be “neither a borrower nor a lender”. Part of Shakespeare’s enduring appeal, of course, is that he wrote about human nature, which never changes. But since Shakespeare’s time, finance has changed so that now there’s such a thing as ‘good’ debt.
Many investors find themselves unable to maximize their RRSP contributions. Particularly the majority of Canadians without workplace pension plans. They can contribute up to 18 per cent of their pre-tax income to their RRSPs. But finding this amount of money is hard, especially given the rising cost of living. Many are also trying to maximize contributions to TFSAs (Tax-Free Savings Accounts) or RESP’s (Registered Education Savings Plans). The fact is, there’s only so much money that people can scrape together.
Beware getting lulled into complacency
Investors can carry forward unused RRSP contribution room into the future. But this lulls some into complacency, so they let their contribution room grow year after year. They promise themselves that they’ll make up for this shortfall in years to come. The trouble is, if an investor can’t maximize his or her RRSP contribution for the 2021 tax year, what are the chances that he or she will do so for the 2022 tax year and have enough money left over to cover last year’s shortfall?
A failure to maximize their RRSP contribution room costs investors money in two ways. First, they miss the RRSP tax break and end up paying more income taxes than necessary.
Even a year can make a big difference
Second, even if these investors do ‘catch up’ and fully reduce their income taxes, making RRSP contributions late hurts them in a second way: Their money will have fewer years to grow. As a result, they’ll benefit less from the power of compounding. Even one year’s delay can make a big difference in the final size of one’s RRSP.
If you have lots of unused RRSP contribution room, consider borrowing the money to maximize your contributions. After all, relatively-low interest rates in recent years have taken the prime rate down to just 3.2 per cent. More important, the RRSP tax break will give you cash to pay down your debt.
Say you have RRSP contribution room of $20,000. You borrow this money and contribute it. If you pay income taxes of 40 per cent, this contribution will generate a tax refund of $8,000 ($20,000 times 0.4). You can use this refund to cut your debt to $12,000. That is, it costs you $12,000 to acquire $20,000 worth of investments. If you invest in high-yield stocks, tax-deferred income on this $20,000 should beat the 3.2 per cent you pay on your loan. Many of our Key stocks yield more than 3.2 per cent.
Keep in mind, however, that you should use this strategy only if your job is secure. Then you can pay down the loan as fast as you can.
At this point, consider investing regularly throughout the year. Say you accumulate $6,000 of contribution room each year. You should consider contributing $500 a month. After all, it’s easier to come up with this than to come up with $6,000 all at once. You might arrange to make pre-authorized contributions to your RRSP. This is where money is automatically moved from your bank account to your RRSP. After all, it’s easier to save money that you don’t see because it disappears into your RRSP.
Also, if you contribute to stock mutual funds, regular investments will give you the benefit of dollar-cost averaging. That is, fixed-sum contributions buy more mutual fund units when prices are lower and fewer units when prices are higher. The end result is that you build up your mutual fund holdings at a decent average price.
If you have trouble coming up with $500 a month, fill in a tax waiver form from the institution where you keep your RRSP. Your local district tax office processes the form and authorizes your employer to reduce the taxes deducted from each paycheque. This leaves you with more take-home pay which, in turn, makes it easier to contribute fully to your RRSP. In effect, you receive your RRSP tax deduction throughout the year, rather than waiting until the following year.
You should borrow to maximize your RRSP only as a last resort. But at least using good debt to do so is relatively cheap.
This is an edited version of an article that was originally published for subscribers in the May 20, 2022 issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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