A good friend came to me this week and shared with me his relationship troubles. I then stretched my mind back to my first-year university psychology class to attempt to remember which cognitive behavioural technique has the most empirical validity for treating this problem.
Maybe I should have been a psychologist. Actually, being an adviser on all things financial often ends up as an exercise in psychology. Today, I want to share some tips based on the psychology associated with registered retirement savings plans.
1. Contribute to an RRSP for the behavioural advantages
When you contribute to your RRSP you can get at your money easily enough. The fact is, however, that there is a psychological barrier – a tax barrier – when Canadians think about making withdrawals from an RRSP. From a behavioural perspective, we tend not to make withdrawals from RRSPs when there is a looming tax hit. This allows your money to stay put for its intended purpose: your retirement. This reason alone may make your decision to contribute to an RRSP over a tax-free savings account (TFSA) an easier one.
2. Contribute to your RRSP over your mortgage
Most people feel greater security when they have RRSP savings available that can act as an emergency fund if necessary. My good friend, financial author Talbot Stevens, has done an analysis on the RRSP versus mortgage debate. Mathematically, you’ll be better off paying down your mortgage only if your interest rate on the mortgage is three percentage points or higher than the return you expect inside your RRSP (a rare situation today), and you take the amount of the mortgage payment and start investing that same amount once your mortgage is paid off (not many have the mental fortitude to stick to this type of plan).
3. Consider an RRSP top-up loan
People tend to be more disciplined about making loan payments to a financial institution than they are about setting aside savings regularly. The reason? Psychologically, there’s greater angst associated with hurting your credit rating by not making a loan payment than in failing to making a regular deposit to an investment account. By borrowing to contribute to your RRSP you are creating a loan payment that acts as a forced savings plan.
Consider borrowing enough to contribute to your RRSP to create a total tax deduction, and potentially a tax refund, sufficient to pay off the entire loan all at once. Suppose you contribute $5,000 of your own money to your RRSP before the March 1 deadline. If you were to borrow an additional $3,333 this month and contribute this to your RRSP, you’d now have total RRSP contributions of $8,333, which can be deducted on your 2012 tax return. If your marginal tax rate is 40 per cent, you can expect a tax refund of $3,333 from this deduction – about the right amount to fully pay off the RRSP loan.
To figure out how much to borrow to create total tax savings sufficient to pay off your loan, the amount borrowed should equal the amount of your own money contributed, divided by the following formula: 1/MTR – 1 (where MTR is your marginal tax rate). If your marginal tax rate is 40 per cent, the formula looks like this: 1 divided by 0.40 is 2.5, subtract 1 equals 1.5. If you contribute $5,000 of your own money, take $5,000, divide it by 1.5, and the answer is $3,333 – the amount to borrow.
4. Consider an RRSP catch-up loan
If you’ve been accumulating RRSP contribution room for a while, you may be behind in saving for retirement. If you borrow to catch up your retirement savings, it’s likely you won’t be able to pay off that loan in a single year.
It can still make sense to create that forced savings plan, even if you pay off your RRSP catch-up loan over a period as long as five years.
Suppose you’re able to afford a $300 monthly payment on an RRSP loan.
If you were to extend the loan over, say, five years, the amount you could borrow would be about $15,500 based on typical five-year RRSP loan rates today. Over the term of five years, you’d pay about $2,482 in interest to the bank, but you would have deferred taxes of $6,200 this year by making a $15,500 contribution, assuming a marginal tax rate of 40 per cent.
The value of that tax deferral will outweigh the interest costs over the several years you have until retirement.