Smart use of RRSP loans

The payback sets you up for the payoff*

Saving for retirement is an important habit to cultivate. We hear about this a lot in January and February each year, as deposits to a registered retirement savings plan (RRSP) in the first 60 days of the year can be claimed as a deduction from the preceding year’s income.

But what if you don’t have the cash readily available to sock into your RRSP? One option is to borrow money for the purpose, using what is known as an RRSP loan. In doing so, keep in mind that this is not intended to be a permanent arrangement, but rather a temporary time-shifting tool. As with any loan, it is important to plan for how and when that loan will be repaid.

To appreciate why early repayment of the loan is so critical, the starting point is to understand how interest on an RRSP loan is treated.

Implications of non-deductible interest

If you borrow money to invest to produce taxable income, your interest cost is generally tax-deductible. However, when a loan is used to make an RRSP contribution, interest is not deductible. While at first this may seem unfair, remember 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

That’s not the end of the story though, as RRSP money will eventually be taxed when it is drawn out of the plan. The combination of non-deductible interest with eventual taxable income should serve as reinforcement to repay an RRSP loan in a timely manner.

How timely? Let’s look at some numbers to help show the cost of that non-deductible interest.

The cost of RRSP loan retirement

For RRSP loan interest, you must first earn income and pay tax on it, and then use what’s left over to pay the interest. To illustrate, we’ll assume a $60,000 income where the marginal tax rate is about 33% (allowing that some provinces are a little higher and others a bit lower). That means $1.50 in pre-tax income would be needed to pay 50 cents of tax, and end up with $1 to make that interest payment.

As a counterpoint, RRSP loans can usually be arranged on more favourable terms than other loans. While it is illegal for a financial insitution to compel you as a borrower to use the loan proceeds to invest with it, the lender is allowed to offer a better rate on the loan if you decide to do so.

But even with favourable rates, don’t forget that the principal will eventually need to be returned to the lender, in addition to interest payments in the meantime. Just as the interest is not tax-deductible, neither is the principal repayment. As well, keep in mind that the tax issues have no effect on your legal obligation to repay the loan, even if the investment decreases in value.

When taking out the loan then, you should already be thinking about how and when you are able to pay it back.

Repayment timeline

Continuing our 33% tax rate example, if the loan is used to make a $6,000 RRSP contribution, it would generate a $2,000 refund. Unless a real emergency occurs between the contribution date and receivng the refund, an immediate paydown of the loan should be the first and only priority for that refund, leaving a $4,000 balance.

According to the Canada Revenue Agency (CRA), you can expect that refund within two weeks if you file online, or up to eight weeks for paper returns. So this year if you file by due date at the end of April, you can have your refund by mid-May. That gives you almost eight months to pay off the remaining $4000 loan (or a little over $500 per month including interest) before the end of the year.

But of course an earlier filing means an earlier refund and an earlier start on those repayments, so if you’re really keen, CRA begins accepting returns as early as the end of February. The reason it is so important to retire the loan by the end of the year is that if payments continue into the following year, there will be less cash available to make the next round of RRSP contributions, whether or not loans are involved.

If that repayment schedule feels unmanageable, perhaps the amount of the RRSP loan should be reconsidered. One approach would be to begin by deciding how much of your monthly cash flow you can comfortably commit to repayments, and let that guide you on the size of loan you can handle.

Strategically getting ahead on your savings

If you are successful in retiring the loan before the end of the year, you can realllocate the monthly cash flow you used for repayment, directly into your RRSP. Whether that’s a few weeks early or a few months, you are paying yourself back with three key benefits:

- First, the earlier the loan is retired, the lower the total interest you will pay.
- Second, those new RRSP contributions will be deductible, whereas the interest and principal repayments on your RRSP loan were not.
- Third, having already begun your RRSP contributions during the year, you won’t need as large an RRSP loan when you come to next year’s first 60 day period. By using this kind of strategic approach, you can progressively wean off of RRSP loans entirely in just a few years, putting your RRSP savings routine on a more stable and sustainable course.

Your financial advisor can help you determine where you are at with your savings presently, whether an RRSP loan fits your needs, and how to manage it so you get the optimal tax benefits from your RRSP savings.

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* Using borrowed money to finance the purchase of securities involves greater risk than purchasing using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines.

To sleep, to wake, to make better financial decisions

Here’s one of those Running Thoughts … Despite (because of?) the pandemic, I’ve been making a point to get out for a run whenever the weather even closely accommodates, and otherwise I’ve been keeping up with my indoor workouts. Either way, the earphones are in, so I’m getting in more audiobooks and podcasts.

I just got through a rather lengthy book this afternoon, Why we sleep from Matthew Walker. This link takes you to Walker’s author page, where you’ll find a link over to Amazon if you want to buy the book – OR, you can do as I did, and borrow it from your local library. In my case, I listened to it on cloudLibrary.

While I didn’t think I was all alone in having occasional sleep challenges, Walker provides an eye-opening view (sorry … typed that before I realized how cheesy, but I’m leaving it) of just how prevalent and problematic sleep challenges can be. He reinforces over and over how drowsiness is worse than drunk driving (in terms of its statistical frequency, not morally speaking).

My own sleep challenges

As a young(er) adult, like many I thought I was almost immune to sleep problems. Once our babies were on the bottle, I was the primary night-feeding designate, as I could be done and back to sleep almost immediately, often 2 or 3 times on a given night. My belief was bolstered (to my detriment) by the ease with which I could rise early for flights, adapt to time zone changes and hotel beds, and fall asleep right after coming back in the door. (Hmm, those regular absences might also explain why I was on tap for baby bottles when I was home.)

Things changed in recent years, with changing job responsibilities, changing jobs altogether, and just changes in me due to age (this last one not boding well, given that I’m not yet at the age when this is more commonly a concern).

Thoughts on sleep and personal finance?

Your ability to focus is significantly impaired if you are not getting 7-9 hours of sleep consistently. Despite the bravado claims of people who burn the candle at both ends, they are paying for that now, and will pay for it in future in terms of weakened health, frayed relationships and reduced life expectancy.

The simplest application of this material is that one should be careful to be well-rested before making any significant financial decision.

And as financial decisions go, a house purchase is the biggest for most of us. If you have been going through bidding wars, you can literally be losing sleep for weeks on end. Walker’s research shows that your cognitive ability declines in a measurable way when this happens. With the very personal nature of a home purchase, there’s a danger that your emotional drive could overtake your logical side. With so much on the line, it’s important to stay alert so you can keep those two influences in balance.

Walker explains how you can’t catch up on lost sleep one night by simply adding the same amount the next. He emphasizes that it doesn’t fit the analogy of accumulating credits that you cash in later.

Looking now at real credit and debt management, that’s the classic situation where people may lose sleep. Your ability to appreciate, analyze and manage your debt will be compromised if you can’t bring your best brain to bear. Staying awake at night (possibly intentionally) could take you down a spiral that causes large and long-term harm. That’s not to suggest that it will automatically be easy with a good night’s sleep, but if you are able to get that sleep then you give yourself much more of a fighting chance.

Walker’s recommendations for good sleep health

Walker has 12 recommendations, and I’m noting here the key points that stood out for me. You can check out the book yourself for the full list:

Have a regular sleep time. This is #1 for a reason! In fact it’s even more important to have an alarm that tells you when to go to sleep than one that tells you when to get up.
Go to bed only when you’re sleepy, and avoid sleeping on the couch
Avoid daytime napping if you’re having trouble sleeping at night. And if you are a napper, don’t do it after 3pm.
Again if you’re having problems, don’t lie in bed more than 20 minutes dwelling on getting to sleep. Get up and do something relaxing until the urge to sleep returns.
Remove anxiety producing worries by learning to decelerate before going to bed.
Understand how the chemical attributes of nicotine, caffeine and alcohol affect sleep, and how they affect your own sleep.

And one last thing … exercise can contribute to greater sleep consistency. Be sure though to finish 2-3 hours before bedtime so that your body is sufficiently cooled down.

3 thoughts on establishing your emergency fund

Published version: Linkedin

For a long time, we didn’t have an emergency fund, though we’ve had a line of credit (LOC) for quite a while.

Our household budget was within our means. We were operating fine in our regular spending routine without having to check when payday was coming. There was also a fair amount of reserve that had built up in the separate accounts we’d established for each of the major expenses.

It wasn’t for fear of holding money in no/low-interest cash that might otherwise be making investment income. No, that’s exactly the effect of those individual accounts anyway. Rather, we were confident in the arithmetic, and didn’t think there was a need to have that one account.

It wasn’t until we had to dip into one of those reserves to replace an appliance that our perspective shifted: Large though that reserve had become, it had a defined purpose and calculated amount that would eventually deplete it. Emergencies aren’t like that.

1. The why of an emergency fund

An emergency fund isn’t about being budget-conscious; it’s about potentially being UNconscious, indisposed and/or impecunious at a time when there remains a budget to be serviced. It’s about you and your ability to be the continuing funding source for your household.

It’s also about being able to respond to large, unexpected expenses. Be careful though not to confuse that with the major expense reserves mentioned above. Years will pass before those needs may arise, but while the exact timing may be unexpected, those remain inevitable.

At the other extreme from normal budgeting are unlikely things such as catastrophic property damage, permanent disability or death. Insurance is for those remote-risk/high-peril events. Between those two is where an emergency fund is situated.

2. LOC or emergency fund – What’s your gut feel?

Part of my own early confidence lay in the fact that as the mortgage was being knocked down, we’d set up a substantial line of credit. It was more than sufficient for the 3 months – or even 6 or 12 months – worth of accessible funds variously suggested to bridge until things would be expected to normalize after an emergency might hit.

But over time I became more familiar with my own emotional relationship with money. Ever since I had a mortgage … I didn’t want one anymore. Though we lived contently and made appropriate allocations to retirement and children’s education savings, the extra dollars were put toward trimming that large liability. That was the mindset and routine while in the midst of stable finance and balanced emotion.

So, how might I feel in a future time of monetary and mental stress, being compelled to dive deeper into debt? Not good in all likelihood. In fact, that prospect could easily exacerbate the impact of any emergency that may in fact arise, and extend out the recovery time. For us, that was when the formal emergency fund took shape, while maintaining the line of credit as the next line of defence.

That’s our family, not necessarily yours. Still, you would do your future-self a great favour by taking the time while things are rosy to contemplate how you will feel when things are not.

3. Deciding your __ months of money?

Assuming you’re committed to the purpose, the first action question to address is how much will you accumulate in that fund? The commonly suggested proxy is, as mentioned above, a certain number of months’ worth of accessible funds. But how many for you: 3, 6, 12, more?

As the timing and extent of an emergency is unknown, there is no formula to provide you with a definitive number. A practical approach is to focus on the most likely of those unlikely events: an employment gap, whether of your own choice or initiated by your employer. Knowing yourself and the industry where you work, how long do you think it would take to get re-situated? Other factors will come into play, like severance pay and employment insurance, but start here as a rough target.

Second, be clear about what this number of months means. In theory it is lost income, but more importantly in an emergency situation, it is the amount of spending that has to be replaced. The two are connected, but the latter continues even in the absence of the former.

Fortunately, unless you’ve been living excessively, your spending will be less than your earnings. Look back at your bank and credit statements over the last year. Take out the truly extraordinary things, and deduct items you can suspend or defer, at least in the short term. This is the monthly average to multiply by your chosen number of months to give you a target.

Third, how much will you regularly deposit into your emergency fund? By “regularly”, I mean weekly or in alignment with your pay cycle, which brings us back to your budgeting. As remote as an emergency may be, you need to assign a percentage or dollar amount that you can commit to, even if that’s a small figure.

Here then is another gut check: Divide your accumulation target by your weekly deposit commitment to tell you how long it will take to get there. If you’re feeling a knot forming in your abdomen, you may want to bump your commitment. Balance that against the discomfort of the current budgetary sacrifice to arrive at a manageable medium.

With a line of credit at your back along the way, you now have a process, timeline and dollar target to get your own emergency fund in place.