If you have been in Canada for a long time, you have likely heard of a registered retirement savings plan (RRSP). The plan was created by the Canadian government in 1957 to help Canadians save for retirement.
Whatever money you contribute will be exempt from your income tax that year. Every year, you can contribute a certain amount. If you go over that amount, you will be charged a fee. If you don’t use it all, it will rollover.
Having unused contribution room can seem wasteful to some, which is why some Canadians choose to take out an RRSP loan. Let’s take a look at what exactly an RRSP loan is and whether it’s a good idea for you or not.
How do RRSP Loans Work in Canada?
If you have an RRSP, you may have realized a lot of your contribution room goes unused each year. For 2020, the contribution limit was $27,230 or 18% of your income. Most people are not able to save this much every year. Since the amount you can contribute to an RRSP will roll over every year, your limit will just keep increasing.
This is not necessarily a bad thing, but since the money you contribute is tax-free until you take it out – see RRSP withdrawal tax – you should take advantage of your contribution room as much as you can. So, many people turn to an RRSP loan.
An RRSP loan is a type of loan Canadians can take out that will be deposited directly into their RRSP account. The purpose of an RRSP loan is to use up your contribution room for the year and take advantage of the money being tax-free. Essentially, you take out the loan to save more money short term.
RRSP loans tend to be very short term, sometimes even just a few months. Many lenders delay when the first payment must be made so you can file your taxes and get a tax refund first. Then, you can use the tax refund to pay back your RRSP loan.
RRSP Loan Options
There are two different types of RRSP loans available in Canada. The first is just a regular RRSP loan. Depending on the lender, you typically need to repay this loan within a year. The first payment can be deferred up to 120 days. During this time, however, interest will still accrue. The regular RRSP loan tends to be the most popular choice as it is a short term investment with a lower interest rate.
The second type of loan is called an RRSP catch-up loan. This is aptly named as you can borrow up to $50,000 to contribute to your RRSP if you have a lot of unused contribution room. This RRSP catch-up loan is typically for a term of 5 to 10 years. The catch-up loan tends to have a higher interest rate than the regular RRSP loan, which can change at any time without notice.
When it Makes Sense to Borrow
Taking out a loan just to put it into your savings may not seem like a sensible thing to do. But, for some people, it can be a beneficial investment. If you are in a high tax bracket, for example, you will likely save more on your tax refund if you contribute more to your RRSP. You can then use your larger refund to pay off the loan, so you’ll only be left paying the interest for a few months.
If you want to save more money for retirement and don’t want to take the risk of investing in bigger things, such as mutual funds or stocks, contributing more to your RRSP is a good start. You just need to ensure you can afford the interest rate you will be charged for the loan. If you can’t, you will be losing more than you’re saving, so it wouldn’t make sense to take out an RRSP loan.
Lastly, this loan makes the most sense as a short term investment, usually less than six months. The quicker you can pay off the loan, the less you will be paying in interest. If you can’t afford to pay off the loan within a few months and your tax refund won’t cover it, it’s usually best not to take out an RRSP loan.
When it Doesn’t Make Sense to Borrow
As we discussed, an RRSP loan does not make sense for everyone. The number one thing to take into consideration is your tax bracket. If you are in a low tax bracket, you will likely not be paying a lot in taxes anyway. Thus, contributing more so you don’t have to claim it on your taxes does not really make sense.
Similarly, the next thing you should consider is the interest rate. Some financial institutions offer interest rates as low as 0.5%. A low-interest rate means you will end up saving more in the end. If it’s too high, you will end up spending more paying off the interest than you would spend on your taxes.
Another thing to consider is how much debt you already have. It’s no secret that most Canadians have debt. We all have credit cards and things we need to buy, so the debt will add up.
If you have credit card debt or any other debt that you need to pay off, you should not take out another loan. You may get stuck with too many loans or too much debt that you get overwhelmed. If you can’t pay it, your credit score will be ruined. It’s best to just stick to paying off your credit cards rather than taking out an unnecessary loan.
To figure out if taking out a loan for your RRSP makes sense for you or not, many banks offer a free RRSP loan calculator.
RRSP Loan Strategies
When taking out loans for your RRSP, there are three different strategies that you could follow to save more money. The first strategy is to “gross-up” your contribution. This strategy is used when you already have money to contribute but want to add more to it to get a bigger refund on your taxes. The bigger your refund is, the more you can put towards paying off your loan quicker.
The next strategy is to “top up” your contribution. This strategy is similar to the first but is used when you don’t have a lot to contribute. That means this strategy is a bit more long term, typically a year compared to a few months. This is because the less you contribute, the lower your refund will be, and thus the longer it will take you to pay off the loan.
The last strategy is called the “catch up” strategy. This is when Canadians take out a big enough loan to use up their entire RRSP contribution room. If you have $20,000 of unused RRSP contribution room, for example, you will take out a loan of $20,000 and contribute it. This tends to lead to a larger refund on your taxes that can then be put towards paying off the loans.
Take Advantage of These Low-interest Rates
As we discussed earlier, it does not make sense to take out an RRSP loan when the interest rate is too high. Thankfully, interest rates are historically low in 2020, making it a great time to take out a loan. Depending on the financial institution, interest rates are, on average, around 2.45%.
The main benefit of taking out a loan with a low-interest rate is that you can pay it off quicker. This is especially beneficial with an RRSP loan as the quicker you pay it off, the more you end up saving tax-free. The higher the rate is, the longer it will take you to pay off, and you may end up losing the money you were trying to save on your taxes.
As rates are historically low right now, it’s a great time to consider taking out an RRSP loan from most banks or financial institutions.
The Bottom Line
As many Canadians have debt from credit cards, tuition, mortgages, and more, we often forget to start saving for retirement. Your retirement will come sooner than you think. Having money put aside in a registered retirement savings plan would thus be beneficial.
The RRSP is then converted to a Registered Retirement Income Fund (RRIF) upon retirement, or before the age of 71. An RRIF enables your savings and investments to grow tax-free.
Even if you do have an RRSP already, you may not be contributing as much as you could. This leaves a lot of unused room in your RRSP that will just continue to roll over. This may be where an RRSP loan comes in handy. You can take out the loan to benefit from a bigger refund on your taxes, which you can then use to pay off the loan.
If you are unsure about whether or not an RRSP loan makes sense for you or not, try out a free RRSP loan calculator. Or, look for the ‘contact us’ section on your financial institution’s website to talk to someone about your unique situation.