Procrastinate, procrastinate, put off all the work I
hate. That's what I've done. It's RRSP time
again, I've spent all my money, and I don't have anything to
put into RRSPs. For the last 4 years it's been the
same story, and my contribution room is getting huge.
I know I should have done my budget 4 years ago when you
first told me to. I'm just too busy, but I have to do
something. I'm getting further and further
behind. I have the desire, but I just don't seem to have the discipline to make monthly
contributions to an RRSP, or make a budget. So, I've
gone down to my friendly bank. They have a great plan
for me - borrow $5,000 at 6% interest for 12 months, put it into my RRSPs, and
get my tax refund back. It sounds like I can't
lose. It's forced savings. It sounds too good to
be true! Is it?
I should mention that I'm 29 years old, live in Ontario, earn $50,000 per
year, and I am married with 2 children. Both
my spouse and I work, and we've listened to you and have
paid down our high-interest debt. We only have our mortgage left, and the
interest rate is 7%. I would like to retire when I'm
60, but we don't have company pensions. What should I
do, old wise one?
Sincerely, Procrastinator
Dear Procrastinator:
I've done the math, and put the numbers through my
super-de-duper computer, and here's what I've come up
with. Using the 9% return from our Recommended
stocks/ETFs for inside or outside of your RRSP article, we have compared the following
alternatives, using 2007 tax rates:
Plan #1: Borrow money from the bank, and use the
tax refund to deposit into your RRSP. Your monthly
payments will be $430.33. The interest on
the bank loan is not tax deductible. With annual
income of $50,000 in Ontario, your marginal tax rate is
31.15%. However, if we include the reduction in the
Ontario Health Premium from your contribution, you save
$1,708 of tax, or 34.16% of the $5,000. The savings can be
calculated using the Canadian
Tax Calculator.
Doing this plan annually, you would have $996,643 in your
RRSP in 30 years. This is a little more money than
Plan #2, because you get your RRSP deposit in immediately,
and your refund is deposited to your RRSP 3 months
later. This is the power of compounding
interest. The problem is, you have to go to the bank
to get a loan every year.
Plan #2: Don't borrow money, but use the loan
payment calculated in Plan #1 plus tax savings as a monthly
deposit to RRSPs. Thus, if you have a $430.33 loan
payment and 34.16% tax savings, you would make a monthly
deposit of $577.33 ($430.33 + (34.16% x $430.33)) to your RRSP. Do
this as an automatic payroll transfer to your RRSP, and the
income tax will be automatically reduced. Once you set
this up, there is nothing else to do unless you change
employers.
With this plan, you would have $989,770 in your RRSP in 30
years.
Plan #3: Don't borrow money, use the loan payment
calculated in Plan #1 as a monthly deposit to RRSPs.
Use the tax savings or refund for living expenses. Set
up and forget, as with Plan #2.
With this plan, you would have $737,753 in your RRSP in 30
years. It is significantly less than plans #1 and #2,
because the tax savings are not going into your RRSP.
Plan #4: Borrow money from the bank, and use
the tax refund to pay down the loan. Off to the bank
every year, as with Plan #1.
With this plan, you would have $742,876 in your RRSP 30 years.
All four of the above plans are good, because you are
putting money into RRSPs. You can go to our Borrow for
RRSPs Calculator, put in your numbers, and work out your own
plan. We recommend using Plan 2, but increasing your RRSP contribution to
15% of your gross earnings (see pay
yourself first). It is the
simplest to do, it is less likely anything will go wrong,
and it is a little better for dollar
cost averaging. With this plan, you would have $1,071,488 in
your RRSP in 30 years. One drawback is that you will
probably only want to make a stock purchase every few months
in order to minimize your commission costs. This will
slightly reduce the returns calculated above. Since you have paid down all your high interest
debt, we recommend that you go to your employer and get them
to automatically transfer your "pay
yourself first" money to your RRSP. If your
employer can't do this, get your financial institution to
make automatic transfers to your RRSP.
Sincerely, Old Wise One
Tax tip:
Before you put money into RRSPs, make sure you can pay off
your mortgage before your children enter university.
Should I borrow more?
Dear Old Wise One:
Since the plan to borrow $5,000 to put money into RRSPs
looked pretty good, should I borrow $50,000, put it in my
RRSP, and pay it off over 10 years?
Sincerely, Procrastinator
Dear Procrastinator:
Theoretically, you will be further ahead because you are
getting your money into your RRSP sooner, but there are some
major drawbacks to this plan.
There are two alternatives to this plan - let's call them
Plan 5 and Plan 6, to continue on with our above analysis.
Plan 5: Borrow $50,000 to contribute to your RRSP,
and put the tax refund into your RRSP.
You can't use all of the contribution in one year.
To maximize your tax savings, you would use $36,000 of the
contribution in the first year, and $14,000 in the second
year. Your total tax savings would be $9,840 plus
$4,584, or $14,424 over 2 years (use the Canadian
Tax Calculator to determine your savings).
This is 28.8% of your contribution.
To keep your payments the same as with the $5,000 loan
you would have to pay back your loan over a period of 14.5
years. This means your next contribution would be made
in 15 years, taking out another loan.
With this plan, you would have $1,083,020 in your RRSP in
30 years, more than with Plans 1 to 4. However, you
have a large outstanding debt which could be a major problem
if anything goes wrong.
Plan 6: Borrow $50,000 to contribute to your RRSP,
and use the tax refund to reduce your loan balance.
This will mean your loan can be paid off in just over 9
years, so you could repeat this process in 10 years and
again in 20 years.
With this plan you would have $1,061,972 in your RRSP in
30 years, more than with Plans 1 to 4.
We don't recommend either Plan 5 or 6 because:
it is not a good idea to put such a large amount of
money into stocks all at once. It is better to dollar
cost average your purchases to reduce your
risk. Plans 2 and 3 are the best for dollar cost
averaging, and Plans 1 and 4 aren't bad.
the large outstanding loan could be a problem in the
event of job loss or extended sickness, or if you have a
financial emergency. You are still making mortgage
payments, so increasing your debt by this much is
probably a poor idea.
Our recommendation is still to use your pay
yourself first money to contribute to an RRSP, through
automatic payroll transfers in order to have your income tax
reduced immediately. You will not have a large
outstanding loan, and in case of financial emergency you
could temporarily stop these transfers.
With all six of these plans, you are still not using your
available contribution room,
which is getting larger and larger, because you can
contribute $9,000 per year and you are only contributing
$5,000 per year. But don't worry. If you stick
to one of these plans (1 to 4) you are on the right
track. You have other things to spend your money on,
such as paying down your mortgage and raising your
children. Once your mortgage is paid off, you will
have more money for either RRSPs or your children's
education. Once your children are finished with their
education, you will find that your wages have probably
increased and you have lower expenses. This is a good
time to catch up on your RRSP contribution room. If
your spouse also uses one of these plans, you should have no
problem retiring when you are 60.
Sincerely, Old Wise One
Every province and territory has different tax rates,
and each person's situation differs. Use our calculators
to compare different scenarios.
The information on this site is not intended to be a
substitute for professional advice. Each person's situation differs, and
a professional advisor can assist you in using the information on this web
site to your best advantage.
See our Business
Directory for tax, accounting and finance-related firms in your
area.
Please see our legal
disclaimer.
