One of the reasons that people rush to make their RRSP contributions before the Feb. 29 deadline is because of the refund they get in April.
They think the refund is a windfall that makes them wealthier, which is one of the big myths about RRSP contributions.
Many also think it’s a good idea to borrow money for the contribution to get the refund, especially with interest rates being so low. While borrowing for your RRSP can work, but it’s not universally a good thing.
Registered Retirement Savings Plans are a great idea. They were Ottawa’s first big incentive to encourage retirement savings, and they were smartly conceived to offer a psychological nudge. By giving you a tax refund, they seem as though they’re giving you something for nothing — so you have the money saved, plus the money back.
But the Canada Revenue Agency isn’t so generous; Like that old TV commercial, it’s case of “pay me now or pay me later.” Here’s a closer look:
Myth #1: 1+1=3
An RRSP contribution plus the refund is not worth more than the contribution.
Here’s an example. Suppose you make a $1,000 contribution, you live in Ontario and make $75,000 a year. Assume your marginal tax rate was 33 per cent in 2015, so your refund was $330. You seemingly have $1,330 for an investment of $1,000.
But the refund just represents tax that you have to pay later, when you take the money out. Say that on the day you get your tax refund, you withdraw the $1,000 from the RRSP. You’ll pay $330 in tax, leaving the $670 plus the $330 refund. A wash.
The only way you come out ahead is if your tax bracket is lower in retirement, when you take money out. In that case, you pay tax at a lower rate than you would today.
And as your nest egg grows inside the RRSP, so does your tax liability. If your RRSP doubles, so your tax bill, assuming no change to your tax rate. The CRA can be patient, but it has a long memory.
Even with a higher tax bill later, the smart thing to do with your refund is put it back into your RRSP. That lets time and the compounding power of interest work for you.
In the above example, you really would get the $1,330 of value — the $1,000 contribution, plus the $330 refund added in. Next year, you’ll get a tax break on that $330, or another $109 back if you’re in the same tax bracket.
Myth #2: Borrowing for an RRSP is always a good idea
Your bank will often encourage you to do this. One argument you might hear is that you can use the refund to help pay down the loan. That’s true, and in some cases loans work. But here are some other things to consider:
Why do you need the loan? Is it because you don’t have the cash? If so, that may mean you have other debts. Far better to pay them off first.
Are you really going to pay it off? If you have the cash but not the discipline, are you likely to repay the loan or just pile it on to your line of credit? The easiest way to get the discipline is through a payroll deduction — set it and forget it.
And remember: RRSP loans aren’t tax deductible. You can deduct the interest expense of loans for non-registered investments, but not RRSPs. Even at today’s low interest rates, borrowing at 3.25 per cent means you have to earn at least that to break even. Who knows where markets will end this year. It’s been a dismal start and it hurts to be paying off a loan for an investment that’s worth less than when you started.
RRSPs are a great way to save for retirement; for some people, they are the only way to fund it. Use them to your best advantage. That may mean putting a little aside every month, reinvesting rather than spending the refund and letting time and compounding interest work in your favour.