Article

Should You Borrow Money to Make an RRSP Contribution?

They will come at you with newspaper, radio and television advertising as well as all forms of brochures and pamphlets explaining just how investing with them is better than putting your money with someone else down the street.

One claim that you are sure to hear over and over again is that everyone who does not have the funds to contribute to an RRSP should borrow money from their bank or trust company to come up with the cash to make the contribution. In many cases, they suggest that the taxpayer use these loans to finance catch up contributions in order to take advantage of any RRSP contribution room that might be available. Thus, the bank is not only suggesting that you borrow say $2,000 to $5,000 but amounts that can be very much higher indeed.

The idea seems simple enough. Suppose the taxpayer borrows $10,000 at 8% to make an RRSP contribution that he is able to repay over the following twelve months. If he is in the highest income tax bracket, his tax refund will be $5,000 that he can immediately apply against the indebtedness. The loan will cost approximately $800 and he will have generated a vehicle for tax sheltered savings.

This is fine as far as it goes. However, just be careful of a few things that never seem to be addressed in the sales literature:

1. Remember that the loan interest cost is non-deductible for income tax purposes and, in the above example, the taxpayer would need $1,600 in pre-tax earnings to extinguish the carrying costs. This is over and above all principal repayments. Unless you are confident that you can make more in your RRSP than the interest charges on your loan, incurring non-deductible expenses is an expensive way to go about saving.

2. If you have the financial resources to be able to meet the monthly repayments that will be due after the income tax refund has been applied to the original loan, then perhaps you should consider two RRSP contributions of $5,000 spread out over two taxation years. This will still get $10,000 working for you on a tax deferred basis but it will happen a bit later rather than sooner.

3. Do not forget that borrowing money for investment purposes can be risky. All the sales literature suggests that your RRSP investment will be collateral for the RRSP loan that has been taken out. What will you do if the value of your RRSP investment drops below the loan that has been used to finance it? And more importantly, what will the financial institution do under this scenario? And …

4. No matter what you do, make sure that your RRSP loan is paid in full by December 31 of the year in which the indebtedness has been incurred.

Article ©1999 The Quarterly Dividend
Reprinted with permission