Canadian financial speaker and author Talbot Stevens has written a new book called, The Smart Debt Coach, which hit the shelves this week. In it he explains a key concept that gets overlooked by most investors: when you’re saving for retirement, you should never put dry pasta in your RRSP.
Related: 5 common RRSP myths
Come again? Here’s how Mr. Stevens explains the pasta analogy in the book:
“Have you ever noticed that when you cook pasta, it expands to be much larger than it was when it was dry? As it soaks up water, it can become twice as big after it’s cooked. And if you let it dry out, it returns to its original size.
Dollars you earn are a lot like pasta. You’re paid with dollars that haven’t been taxed yet. Before-tax dollars are like larger, wet, cooked pasta. But after federal and provincial income taxes suck all the water out, you’re left with after-tax dollars – smaller, dry pasta.
If you don’t put the equivalent, before-tax amount in your RRSP, you end up unknowingly investing less than you start with, less than you intended, and less than you need to.
One of the behavioural risks of RRSPs is that by spending the refund, you end up converting after-tax dollars to less valuable before-tax dollars, probably without realizing it.”
Five RRSP refund strategies to consider
Strategy one: Spend the refund – When you make a $3,000 RRSP contribution, assuming a 40 percent tax bracket, you’ll generate a $1,200 tax refund. Most of us spend the refund – some of us even plan out how we’ll spend the refund before we do our taxes.
“The common approach, of spending the RRSP-generated refund, is obviously the least effective, yet it is the most widely used of all the refund strategies,” said Mr. Stevens.
Related: What to do with your tax refund?
Back to the pasta analogy, let’s say you start out with $3,000 of after-tax money to invest – smaller, dry pasta. If you contribute it to an RRSP and spend the $1,200 refund, you end up investing only $1,800 after tax. That’s your net, after-refund contribution to your retirement.
Strategy two: Reinvest the refund – A more disciplined and committed saver might choose to reinvest their tax refund. When you add the $1,200 refund to your $3,000 contribution, you’ve increased your RRSP deposit to $4,200 – a 40 percent improvement.
Mr. Stevens says that while this approach is better than spending the refund, reinvesting it still does not give you the initial, after-tax amount that you started with. In other words, $3,000 after tax equates to $5,000 before tax.
“It means putting partially cooked pasta in your RRSP,” he said.
That brings us to the RRSP gross-up strategy.
Strategy three: “Gross up” the refund – The Gross-up strategy converts the after-tax amount available to invest into the equivalent, before-tax amount in your RRSP.
The easiest way to achieve this result is to use a temporary gross-up loan, where you borrow an amount equal to the refund that will be produced by the RRSP contribution.
In this case, you’d need to borrow $2,000 to gross up your $3,000 after-tax dollars to the equivalent $5,000 amount in your RRSP.
Related: Check out the RRSP gross-up calculator on Talbot Stevens’ website.
You’ll get a $2,000 tax refund, which is enough to completely pay off the loan. The gross-up loan allows you to turn your $3,000 to invest into a $5,000 RRSP contribution, which means you end up with 67 percent more saved in your RRSP.
This is what Mr. Stevens meant when he said you should only ever put fully cooked pasta into your RRSP.
Strategy four: Top-up loan – With this approach you use a small, short-term loan to “top up” an annual RRSP contribution. Say your RRSP contribution room was $4,000 and you only had $1,000 available to invest: you could borrow the extra $3,000.
Unlike with the gross-up strategy, where you use the refund to immediately pay off the loan, your $2,000 tax refund could pay off most, but not all, of the loan.
“Top-up loans are typically paid off in less than a year,” said Mr. Stevens.
Strategy five: Catch-up loan – With this approach you use a larger “catch-up” loan that could take anywhere from five to 15 years to repay. Borrowing a larger amount may allow you to catch up on unused RRSP contribution room – at least, temporarily.
“Since most clients don’t maximize their RRSP every year, some have accumulated more than $30,000 of RRSP room that may never be used,” said Mr. Stevens.
I spoke with Talbot Stevens earlier this week and asked him about my RRSP loan strategy, which he said falls into strategy number four. He agreed that one of the main benefits to this approach was the forced discipline of having to repay the loan.
He said the biggest challenge we face is behavioral – we spend all or most of our refund – and so we don’t take full advantage of our RRSP contributions.
Reinvesting or grossing up your tax refund is a simple way to increase your retirement funds.