In The Tragedy of Hamlet, Prince of Denmark, Polonius warns his son Laertes to “neither a borrower nor a lender be”. Part of Shakespeare’s enduring appeal, of course, is that he wrote about human nature, which never changes. But since the 17th century, finance has changed a great deal. Now there’s such a thing as ‘good’ debt.
Much lower interest rates have made it cheaper to borrow in recent years. If you cannot maximize your RRSP contributions, consider borrowing to do so—as a last resort.
Many investors find themselves unable to maximize their RRSP contributions. Particularly those who belong to no pension plan, since they can contribute up to 18 per cent of their pre-tax income to their RRSPs. But coming up with this kind of money is often difficult.
Can you come up with 18 per cent?
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 this shortfall in the years to come. Trouble is, if an investor can’t maximize his or her RRSP contribution for the 2016 tax year, what are the chances that he or she will do so for the 2017 tax year and have enough money left over to cover this 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 is necessary.
Make sure your tax break compounds
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 find yourself with significant unused RRSP contribution room, consider borrowing the money to maximize your RRSP contributions. After all, the dramatic drop in interest rates in recent years makes makes it cheaper to borrow More important, the RRSP tax break will give you the cash to pay down your debt. Let’s consider an example.
Say you have unused RRSP contribution room of $20,000. You borrow this money and contribute it to your RRSP. 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 tax refund to reduce your debt to $12,000. In other words, it costs you $12,000 to acquire $20,000 worth of financial assets. If you invest sensibly, tax-deferred income on this $20,000 should beat the low interest that you pay on your loan.
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. Let’s 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 it is to come up with $6,000 in one fell swoop. 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.
Invest regularly throughout the year
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 when prices are higher. The end result is that you build up your mutual fund holdings at an attractively-low average price.
If you have trouble coming up with $500 a month, fill in the tax form to take deductions in advance. 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 the 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 now is cheaper than ever.
The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846