What Does Pasta Have To Do With RRSPs?
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.
Related: How an RRSP loan turned my $12,000 contribution into $20,000
“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.
Final thoughts
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.
Related: Withdrawing from your RRSP early may cost you
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.
What category does putting the tax refund into a TFSA fall under? #2?
@Joe – I asked the question to Talbot Stevens and here’s what he had to say:
Investing the full, equivalent, before-tax amount in an RRSP is what Canadians should be doing, and in my metaphor is analogous to fully cooked pasta.
Working through the example for someone in a 40% tax bracket, if they contribute $3,000 to their RRSP and put the $1,200 refund into TFSA, they have $1,800 after-tax dollars in their RRSP and $1,200 after-tax dollars in their TFSA. So this means they have invested the full amount they started with and thus fully cooked pasta.
You’ve identified a hybrid strategy that might be called fully cooked, multi-colour (white and green) pasta!
Extending the theme, since you’re already thinking it, is acknowledging that someone who uses the refund to pay down non-deductible debt is also productively investing all after-tax dollars that they started with. Thus, this is also fully cooked, multi-coloured pasta, perhaps white and red.
However, many might not fully reconcile that they’ve really only put $1,800 of their initial $3,000 in their RRSP … because their RRSP balance goes up by $3,000.
The important point is understanding that $3,000 after taxes to invest equals $5,000 before tax, and thus a $5,000 RRSP contribution.
The related point is that only reinvesting the $1,200 refund back into RRSPs does not reinvest all of the after-tax fuel in one’s retirement vehicle that one started with.
Why? Because we haven’t defined what happens to the second RRSP refund. If it is spent, then the after-tax amount invested would be $4,200 x (1 – 40%) = $2,520. This is less than the $3,000 after tax that we started with … and thus only partially cooked pasta.
(If you’re one of the few weirdos like me who appreciates applied math, note that if the RRSP refunds where all reinvested, indefinitely, the sum of all of these cash flows would total the same grossed up amount. But you would have to ignore the one-year time lag between refunds.)
-Talbot Stevens
I think strategy #1 is by far the most common as people feel entitled to spend once they get their refund back. We try to avoid the temptation by dealing with the money right away – either reinvesting it (#2) or using it to pay down the mortgage
@Dan – This is my first crack at the top-up loan strategy. I’ll get to do it one more time, next year, before I run out of contribution room.
Very clever analogy. I’ve never thought of it like that, but this is a great way to explain pre-tax investing to most folks. I’m sure the book will do well 🙂
Strategy six. Remove RRSP’s from the tax refund discussion. Work hard to make refunds a thing of the past. Tax refunds are good for the country, bad for the individual.
I make it a goal to make sure I OWE the government as much as possible at tax time: that means I have been using their money all year. This is easier to do for some than others depending on your income source. I hate a refund unless it is from a calculation error. A refund means the government has been using money all year that they consider to be mine, which is just silly if you can avoid it.
Of course, do all you can to reduce taxation legally including RRSP deposits. But anticipate your taxes so that you owe the government at tax time if possible.
Note: if you do this and do not religiously set aside the money you owe the government you are courting disaster.
@Robert – Definitely, if you contribute to your RRSP monthly then you should get your payroll taxes reduced at the source by filling out form T1213.
Great strategies along as you don’t have any debt.
I was just going to mention that!
That should be strategy #6 as long as you only have mortgage debt. Any debt on credit card should not have any RRSP contributions that year!
Absolutely – paying off high-interest debt needs to take priority over RRSP contributions.
It’s an interesting strategy but I think it has a few flaws. The point of an RRSP is to contribute when you are in a high tax bracket and take it out when you’re in a low one. Low tax bracket people should be putting any savings in a TFSA and never in an RRSP. You’d have to crunch the numbers, but a better strategy might be to pay down your mortgage with your tax refund. Any interest you are paying with after tax dollars should usually be reduced or avoided. If you end up dying before you take out all your RRSP or RRIF you won’t miss it anyway – and I’m not forgetting you can roll it over tax deferred to your spouse.
@Alan – The problem, as Mr. Stevens sees it, is behavioural. On paper, the TFSA and RRSP are mirror images of each other and in some cases the math favours TFSA contributions. But the TFSA is not really geared toward retirement savings in most of our eyes. It’s right there in the name, tax free SAVINGS account. Many people use it for short term savings and can be tempted to withdraw the money at any time without penalty. Easy access.
RRSPs, on the other hand, have a higher barrier that may prevent people from raiding them early or unnecessarily.
It’s like the rent vs. buy argument where renting makes sense only when you are disciplined enough to save and invest the difference.
This is great for those who are employees. For those of us who are self-employed, there is no refund per se, just a reduction in the tax bill at the end of the year. And figuring out the quarterly remittances so that you pay just enough and no more, is not as easy as it sounds given all the factors involved.