The concept of the RRSP loan is firmly ingrained in our collective retirement savings psyche. Whether to enable a current year contribution or as a means of catching up on past unused room, the process can be a catalyst that spurs on the savings habit.
Still, it should be kept in mind that this cannot be a permanent arrangement, but rather a temporary time-shifting tool. As with any loan, there must be a plan for how and when that loan will be retired. After all, it’s not free money.
And at the core of appreciating the value proposition is the need to have a clear understanding of how interest on an RRSP loan is treated.
Interest not tax deductible
Where money is borrowed and put to an income-producing purpose, interest payments are generally tax deductible. This general rule applies to non-registered accounts, and rests on the potential for dividend or interest income, both taxed annually as earned.
On the other hand, where a loan is undertaken in order to make an RRSP contribution, interest is not deductible. To some that may seem unfair, but there is a quid pro quo logic behind this treatment, in that income and growth within an RRSP are not subject to tax.
Thus there is an element of symmetry in this comparison: deductibility with taxable income, non-deductibility with tax-exempt income.
Bear in mind though that for either account type, the eventual drawdown will be taxable. That would mean one-half taxation on capital gains when cashing out a non-registered account, compared to full taxation of money coming out of a registered account.
The combination of non-deductible interest with eventual taxable income should serve as reinforcement to retire an RRSP loan in a timely manner. How timely? Well, let’s look a little closer at the cost of that non-deductible interest.
Servicing RRSP loans
To pay this interest, one must earn income, pay tax, then pay the interest. Allowing for provincial variations, someone at $50,000 income faces about a 33% marginal tax rate. It therefore costs this person $1.50 in pre-tax income to pay a dollar of interest.
As a counterpoint, RRSP loans are always available at very favourable rates, often only a percentage point above prime rate, or even less. With prime at 3% in early 2013, the current range is about 3.5% to 6%.
Beneficial though that may be, remember that the principal will eventually need to be returned to the lender, in addition to interest payments in the meanwhile. Just as the interest is not tax-deductible, neither is the principal repayment.
Hopefully this casts things in fuller light, making it clear that the pre-tax cost of making the contribution is essentially 150% of the amount borrowed in our example.
Payback timeline
This kind of analysis is what underlies the common recommendation to use one’s tax refund to reduce RRSP loan principal. Absent a real emergency arising between the time of contribution and tax refund, this should be the first and only priority for that refund.
Beyond that, the borrower should endeavour to retire the entire loan within the year. In fact, if it can be retired sooner then the monthly cash flow earmarked for repayment can instead be allocated directly into deductible RRSP contributions, progressively weaning away from the need for RRSP loans as the years pass.
On the other hand, if that loan remains outstanding beyond the year, it then affects the person’s capacity to make later RRSP contributions, with or without the assistance of RRSP loans.
Overall, and guided by these principles, RRSP loans can indeed be helpful in encouraging savings. In particular, a better understanding of the interest component can push a person further along that savings path towards realizing retirement goals.