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Monday, March 11th, 2024

When borrowing to save makes sense

According to the British tabloid the Sunday Mirror, a well-intentioned 33-year-old woman by the name of Cherie Beekman volunteered her time last April to work with some young people. She took the youth group to a bowling alley in Didsbury, England, for some fun, but somehow ended up with her thumb stuck in her bowling ball. It took firemen over two hours using an electric saw, hacksaw, and a chisel to free her thumb. When going for a strike, her intentions were very good. Her execution wasn’t quite as good.

Many Canadians suffer the same problem when it comes to saving for retirement. Intentions are very good, but things fall apart in the execution. Unfortunately, an electric saw, hacksaw, and chisel won’t help much when it comes to saving.

Since it’s RRSP season, I want to talk about borrowing to contribute to your RRSP as a means of bolstering your savings.

Borrowing to contribute

Borrowing to contribute to your RRSP can make good sense if you have significant unused contribution room and simply won’t be able to use up that room otherwise. Think of the loan payments as a forced savings plan. Paying down the loan quickly can make sense because, among other reasons, you won’t be entitled to a tax deduction for the interest on a loan to contribute to your RRSP.

Here’s a game plan to consider: Contribute some of your own cash, then borrow additional funds to increase your RRSP contribution. Borrow enough to contribute to your RRSP to create a total tax deduction that will pay off your loan entirely with your expected tax savings (which often comes back as a tax refund).

Okay, clear as mud. Here’s an example: Martin contributes $5,000 of his own money to his RRSP before Mar. 1, 2011 (the deadline to claim the RRSP deduction on his 2010 tax return). He wants to add to this total by borrowing to contribute more to his plan. He also wants to pay off the loan with the tax refund he’s expecting to receive as a result of his RRSP contributions. How does he do this? Martin borrows $4,092 from his bank this month and contributes the proceeds to his RRSP before the deadline for total RRSP contributions of $9,092 deductible on his 2010 tax return. Given his marginal tax rate of 45 per cent, Martin expects a tax refund of $4,092 from these contributions – the right amount to fully pay off his loan.

So, how did Martin figure out the amount to borrow to create tax savings that will pay off the RRSP loan? There’s an ugly formula he used to do the math. The amount of the loan should equal the amount of his own money that he contributed, divided by the following: 1/MTR – 1 (where MTR is his marginal tax rate). Martin’s MTR is 45 per cent.

The formula provides the following result: 1 divided by 0.45 is 2.222, subtract 1 equals 1.222. Martin contributed $5,000 of his own money to his RRSP. So, take $5,000, divide it by 1.222, and the answer is $4,092, which is the amount Martin is going to borrow.

Contribute in kind

One challenge is that you won’t be able to deduct your interest costs if you borrow to contribute to your RRSP. And so, here’s another idea to consider: If you happen to have non-registered investments outside your RRSP, consider contributing some of those investments to your RRSP as a contribution-in-kind. You’ll receive the same RRSP deduction for the contribution to your plan as you would have received had you contributed cash.

You can then borrow to replace the investments that were held outside your RRSP. In this case, you’ll be entitled to a deduction for the interest costs on the loan because you’ll be investing the borrowed money outside the RRSP. This will save you taxes.

You should be aware that those investments you contribute in-kind to your RRSP will be deemed to have been sold at fair market value when you make the transfer into your RRSP, which could trigger a taxable capital gain if the investments have appreciated in value. The good news? The RRSP deduction will more than offset that taxable capital gain if you have sufficient RRSP contribution room. If you trigger a capital loss when transferring assets to your RRSP, the loss will be denied. So, it will make sense to sell those losers on the open market first, then contribute the cash to your RRSP. You’ll be entitled to the capital loss in this case.

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