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Borrowing from Peter to pay yourself
It sounds counter-intuitive, but taking out a loan to tuck away in your RRSP could pay off
JEFF BUCKSTEIN
When Graham Duncan found himself $10,000 short of being able to top up his registered retirement savings plan contribution in 2005, he turned to the bank for an RRSP loan.
He knew there was a good chance he would make a greater return on the borrowed money by investing it in the market than the 4-per-cent interest he would pay on it.
"Plus I got two benefits," Mr. Duncan says. "First through immediate tax savings, then by being able to earn long-term compound interest for that total amount up front in my RRSP."
In fact, that financial strategy proved so successful that the Calgary-based energy-trading analyst is leaning toward taking out another RRSP loan this year.
Borrowing to contribute to an RRSP when cash is short can be immensely beneficial to plan holders, experts say, both over the short term, via immediate tax savings, and over the long haul because of tax-free compounding that provides an added cushion for retirement.
"An RRSP loan is a really good idea. It allows for flexibility, forced savings and tax-deferred growth," says Kirk Anderson, a Calgary-based financial planner with RBC Investments, which provided Mr. Duncan his loan.
Mr. Anderson estimates that nearly 20 per cent of his clients take out an RRSP loan of about $5,000 each to top up their annual contribution.
An RRSP loan "gets the money committed to your RRSP savings plan that much sooner, so it has more time to grow tax-sheltered," says Sandra Sigurdson, manager of strategic investment planning at Investors Group Financial Services Inc. in Winnipeg.
To illustrate how effective this strategy can be, consider that under the mathematical "rule of 72," if an RRSP portfolio is able to generate growth at a conservative annual average rate of 6 per cent, the money in that plan would double each 12 years. Thus, $5,000 in borrowed funds invested in 2006 would grow to $10,000, minus servicing costs for the loan, by 2018. Depending on the age of the contributor and length of time he or she keeps the money in a plan, that could add up to a significant amount over the course of a lifetime.
"That's the magic of compounding," explains Cherith Cayford, director of CMG Financial Education in Victoria.
Moreover, with Canadian investors lagging well behind their potential in saving for retirement, many financial analysts say the strategy is a highly effective way of closing some of that gap.
For example, Statistics Canada reports that the aggregate RRSP contribution of Canadians in 2004 was $28.8 billion, only about 7 per cent of the total room available. With the maximum contribution limit continuing to increase steadily - in 2006 it is the lesser of $18,000 or 18 per cent of the previous year's earned income - that gap is expected to widen even further.
Many other factors make RRSP loans a worthwhile consideration. The fact that interest rates are still relatively low - the Canadian chartered bank prime rate was 5 per cent at the start of 2006 - contributes to a favourable borrowing environment. For example, RBC Investments offers its customers variable RRSP loans at prime, provided such loans can be paid back within the first year, Mr. Anderson says. That rate increases to prime plus 1 per cent for loans that are repaid in one to two years.
Many RBC Investments clients have also elected to use a low-rate line of credit to top up their RRSPs, says Mr. Anderson, who points out that once such a line has been established it can be maintained without the customer having to reapply in future years.
Paying down the loan creates an enforced method of savings and discipline, experts say. A smart repayment strategy, they add, is to immediately apply any tax savings generated by the RRSP contribution toward paying down the loan's principal. Some financial institutions will waive interest payments for as long as 120 days to allow the customer to get his or her refund and do this.
In order to pay off the loan as quickly as possible, many financial institutions also provide customers with the opportunity to prepay the outstanding RRSP principal at any time.
Assuming a top marginal income-tax rate of 39 per cent in Alberta, for instance, for every $1,000 in RRSP loans, an individual would be able to reduce the tax payable or be issued a refund for $390; if applied to the loan principal, this would immediately reduce the deficit to $610.
The rest of the loan repayments could then be made over a period of time determined by such factors as the amount of debt that needs to be serviced, the prevailing interest rates and availability of cash.
However, borrowers need to "make sure they are realistic about the monthly payment they can make on their loan, because they don't want the loan to drag on for a long time. That would reduce the value of this strategy," says Ms. Sigurdson.
Moreover, "they should aim at having a short repayment period and be sure the commitment to repaying their RRSP loan isn't going to cause them to forgo servicing other debt," she adds.
Many experts, like Jack Lumsden, recommend paying down a loan within a maximum of one year, as Mr. Duncan has done with his.
"I think from a psychological standpoint, it's probably better to borrow only what you can afford to pay off in a single year," says the senior financial adviser at Assante Financial Management Ltd. in Burlington, Ont.
An RRSP loan doesn't necessarily have to be applied to contributions in one's own plan. It can also be used to contribute to spousal RRSPs which, if established properly, can assist a couple even out their taxable income at retirement, Ms. Cayford says.
Financial advisers also stress that whereas most people take out an RRSP loan at the end of the season - usually to beat the March 1 deadline for inclusion during the previous calendar year - a loan can also be taken out at the beginning of the year in order to maximize RRSP compounding up to 12 months sooner.
Special to The Globe and Mail
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