You have RRSP contribution room, but you don’t have the cash to contribute. Now what?
Contributing to an RRSP will help you save on taxes and may even get a tax refund. More importantly, you are investing money on a tax-deferred basis and building up your retirement savings. But what if you don’t have enough money to make a contribution? Should you borrow to invest in your RRSP?
What to consider before getting an RRSP loan
The following factors need to be considered:
- Your taxable income. If you’re in a lower tax bracket, there may be minimal tax advantage to making a large RRSP contribution. Using the RRSP deduction in a year when you’re at a higher tax rate will reduce your income at the higher rate and provide greater tax savings.
- Paying back the loan. If you can’t afford to pay the loan back within a year, it probably doesn’t make sense to add more to your overall debt load. If you’re planning to use a tax refund to pay off the loan, you’ll need to be disciplined about applying the refund to the loan.
- Your level of debt. If you’re already paying high interest on credit card debts, for example, your priority should be on paying down this debt as quickly as possible, not going further into debt.
- Interest rates. Borrowing money when interest rates are high can be costly. Interest charges can add up, and offset the initial benefit of making the RRSP contribution. Interest on money borrowed to contribute to an RRSP is not tax deductible. You have to ensure that the returns on your investment are greater than the borrowing costs. If your interest rate is tied to a floating or prime rate, your borrowing costs can increase, or decrease.
Alternatives to borrowing to invest
Rather than borrowing money for your RRSP contributions and paying monthly interest charges, it may be in your best interest to set up a monthly contribution plan to an RRSP. Although this will eliminate this year’s tax advantage and delay your tax-deferred investment, you will be ahead of the game for next year. By making regular, scheduled contributions, you can avoid having to play catch up in future years. And, depending on the type of investment you make, a regular, monthly RRSP contribution allows you to take advantage of dollar cost averaging. Dollar cost averaging is an investment strategy designed to reduce volatility in your portfolio. By purchasing investments in fixed increments, rather than all at once, your purchase price is averaged over time, decreasing your risk of overpaying (for example, when the investment is experiencing a high).
Although contributing to your RRSP is an integral part of saving for retirement, an RRSP loan may not be the best strategy. An RRSP loan is generally recommended only when the following conditions apply:
- You’re in a high, or the highest tax bracket, and
- You can pay off the loan within one year, and
- You’ll still be able to make the current year’s RRSP contributions from your cash flow, so you’re not forced to borrow again in future years.
Confirming whether an RRSP loan is the right way to invest for your retirement will depend on many factors. An experienced financial advisor can help you determine whether an RRSP loan or other investment strategy is right for you.