The idea that an RRSP loan can boost your savings and generate a higher tax refund does not sit well with most people. If you can afford the loan payment then why not just budget and save that amount in the first place instead of borrowing?
In The Wealthy Barber Returns, author David Chilton describes a strategy that can increase your RRSP contributions without putting you out of pocket any more than what you’d already planned to save. He explains how most of us save from our after-tax income, but when we contribute only those after-tax dollars instead of their pre-tax equivalent, we shortchange our RRSPs.
So how do you get the full, pre-tax amount into your RRSP? The answer is to use something called an RRSP gross-up strategy where you borrow a small amount equal to the tax refund that will be produced by your RRSP contribution. Here’s how it works:
Let’s say you are in a 40 percent tax bracket and had $3,000 after taxes to invest. How much should you contribute to your RRSP?
If you’re not sure of the answer, you’re probably like the majority of Canadians who unknowingly invest less than they could into their RRSP, according to Talbot Stevens, author of a book called The Smart Debt Coach.
In this case, Mr. Stevens says you should put $5,000 into your RRSP. To do this you’d have to borrow $2,000 to “gross-up” your $3,000 after-tax dollars to get the pre-tax equivalent of $5,000 in your RRSP.
Your $5,000 RRSP contribution will generate a $2,000 tax refund, which is enough to completely pay off your loan. The RRSP gross-up loan allows you to turn $3,000 into a $5,000 RRSP contribution, which means you end up with 67 percent more saved in your RRSP.
Mr. Stevens takes credit for pushing Chilton to include this powerful, yet poorly understood concept in his book. He has a free calculator on his website to help you determine how much you could increase your RRSP contribution, for your tax bracket. Simply enter the after-tax amount you have available to invest, and then enter your marginal tax rate to calculate the “gross-up” amount.
Reading The Smart Debt Coach changed my opinion on using RRSP loans and I’ve actually used a form of the gross-up strategy in each of the last two years. I borrowed $20,000 to top-up my RRSP in 2014 and then earlier this year I took advantage of a 1.5% RRSP loan offer from Tangerine and borrowed $8,000 to contribute to my RRSP. It turns out that I like the forced-savings aspect paying back the loan over a 9-to-12 month period.
Using an RRSP loan can be a powerful strategy to boost your RRSP contributions and build your retirement portfolio. However, use caution whenever you borrow to invest and remember that this solution only works when you have the discipline to save your tax refund or use it to help pay off the loan.