Great Article from Gordon Pape - RRSP Expert - ``Last Minute RRSP thoughts``
We’re coming down to the wire for RRSP season so if you’re going to make a contribution, you’ll have to act soon. Before you do, however, here are some last-minute thoughts to consider.
RRSPs and debt reduction
There has been some debate in the media about whether it is better to pay down debt or make an RRSP contribution. One way to approach the decision is to look at the relative returns from each option. Will you be better off by having the money working for you in a tax-sheltered environment or by reducing the amount of interest you pay each month?
If the debt you’re considering is a high-interest credit card with an astronomical rate (19.99 percent is common) then it’s a no-brainer. There is no way you are going to generate that kind of return in an RRSP, at least not with any consistency. Even if you have a low-interest card such as the SmartLine Platinum MasterCard which offers a rate of 5.99 percent for three years, you may not be able to do as well in your RRSP.
However, if the debt you’re looking at is a low-interest mortgage the decision may be more difficult. For example, Royal Bank is currently offering (until Feb. 29) a closed seven-year mortgage for 3.99 percent. If you invest your RRSP money in a GIC you won’t be able to match that return. But if you invest in a diversified portfolio that averages a gain of 6 percent annually (which I maintain is very achievable) you’ll do better over time.
I have not taken into account the impact of taxes in these examples as they will vary depending on the individual. Any savings on interest costs have no tax consequences whereas an RRSP contribution will generate a tax refund. Be sure to consider this aspect before making a final decision.
If you need more help, there is a very detailed RRSP vs. mortgage calculator here. Mortgage vs RRSP
If the debt you’re considering is a high-interest credit card with an astronomical rate (19.99 percent is common) then it’s a no-brainer. There is no way you are going to generate that kind of return in an RRSP, at least not with any consistency. Even if you have a low-interest card such as the SmartLine Platinum MasterCard which offers a rate of 5.99 percent for three years, you may not be able to do as well in your RRSP.
However, if the debt you’re looking at is a low-interest mortgage the decision may be more difficult. For example, Royal Bank is currently offering (until Feb. 29) a closed seven-year mortgage for 3.99 percent. If you invest your RRSP money in a GIC you won’t be able to match that return. But if you invest in a diversified portfolio that averages a gain of 6 percent annually (which I maintain is very achievable) you’ll do better over time.
I have not taken into account the impact of taxes in these examples as they will vary depending on the individual. Any savings on interest costs have no tax consequences whereas an RRSP contribution will generate a tax refund. Be sure to consider this aspect before making a final decision.
If you need more help, there is a very detailed RRSP vs. mortgage calculator here. Mortgage vs RRSP
Borrow or not?
Another hot topic this year is whether or not people should borrow to make an RRSP contribution. My view has always been that this kind of leverage is a good idea, provided the loan is paid off within two years at the most (one year is preferable). If that does not appear to be feasible, don’t do it.
The math works like this. Let’s assume a marginal tax rate of 35 percent and an RRSP contribution of $10,000, which you borrow against a line of credit at 4 percent interest. That generates a tax refund of $3,500. Then let’s assume the invested money earns 5 percent in the first year, adding another $500 to the RRSP. Your total return in year one is $4,000 or 40 percent on the borrowed money. If you discharge the loan over one year, the monthly cost will be $851.50 and your total interest expense will be $217.99. That’s a small price to pay for a $4,000 gain.
However, if you take five years to pay off the loan, your total interest expense increases to about $1,050. After 10 years, it is up to $2,150. So the longer you take to discharge the debt, the less effective the strategy becomes. And of course, if the loan interest rate is higher, the cost will be even greater.
The math works like this. Let’s assume a marginal tax rate of 35 percent and an RRSP contribution of $10,000, which you borrow against a line of credit at 4 percent interest. That generates a tax refund of $3,500. Then let’s assume the invested money earns 5 percent in the first year, adding another $500 to the RRSP. Your total return in year one is $4,000 or 40 percent on the borrowed money. If you discharge the loan over one year, the monthly cost will be $851.50 and your total interest expense will be $217.99. That’s a small price to pay for a $4,000 gain.
However, if you take five years to pay off the loan, your total interest expense increases to about $1,050. After 10 years, it is up to $2,150. So the longer you take to discharge the debt, the less effective the strategy becomes. And of course, if the loan interest rate is higher, the cost will be even greater.
Starting young
We all know that the more years that money compounds, the greater the end value. An investment of $1,000 compounding at 6 percent will be worth $3,207 after 20 years. But after 40 years that balloons to $10,285. So it’s a good idea to start saving early as there is no age limit for opening an RRSP. The only criterion is earned income. If your teenager earns money from a paper route, babysitting, lawn mowing, or a summer job and files a tax return, he/she can open an RRSP and make a contribution.
What’s more, and this is very important, the tax deduction does not have to be claimed for the year it was made. It can be carried forward until the youngster has finished school and has a full-time job with adequate income to make the deduction worthwhile. Meantime, the contributions have been growing in the plan, giving him or her a great head start on savings. And remember that the RRSP money does not have to be used for retirement only. It can also be put towards buying a first home or continuing education, through the Home Buyers’ Plan and the Lifelong Learning Plan.
What’s more, and this is very important, the tax deduction does not have to be claimed for the year it was made. It can be carried forward until the youngster has finished school and has a full-time job with adequate income to make the deduction worthwhile. Meantime, the contributions have been growing in the plan, giving him or her a great head start on savings. And remember that the RRSP money does not have to be used for retirement only. It can also be put towards buying a first home or continuing education, through the Home Buyers’ Plan and the Lifelong Learning Plan.
Contributions in kind
If you don’t have the cash for a contribution and own a self-directed RRSP, consider making a contribution in kind. This involves transferring a security you already own in a non-registered account directly into the plan. Stocks, mutual funds, GICs, bonds, etc. are all eligible. You will receive a tax receipt for the value of the security on the day it goes into the plan (not the original price you paid).
A word of caution. The Canada Revenue Agency takes the position that the transfer is a deemed sale. That means any profit you have earned to date on the security (interest, dividends, capital gains) will be taxable. However, you may not claim a loss for a security that is worth less than you paid for it. In that case, sell it into the market and use the cash to make the RRSP contribution. This enables you to claim a capital loss when you file your tax return.
A word of caution. The Canada Revenue Agency takes the position that the transfer is a deemed sale. That means any profit you have earned to date on the security (interest, dividends, capital gains) will be taxable. However, you may not claim a loss for a security that is worth less than you paid for it. In that case, sell it into the market and use the cash to make the RRSP contribution. This enables you to claim a capital loss when you file your tax return.
“Low returns”
One newspaper published an interview last week with a Toronto financial analyst who said he would not make an RRSP contribution this year “because the return on investment is really low”. This excuse would be understandable from someone who does not know much about investing but I was shocked to see it from a financial analyst. The reference appeared to be to GIC returns, which are very low (in most cases below the rate of inflation). But RRSP money does not have to be invested in GICs and, in my opinion, should not be at a time when rates are low. The average Canadian Neutral Balanced fund has returned 6.34 percent annually over the past 20 years. That’s a respectable rate of return: every $1,000 invested then would be worth more than $3,400 today.
The deadline
Finally, if you’re a genuine down-to-the-wire investor, keep a close watch on the calendar. Normally the last day for RRSP contributions to be eligible for deduction in the previous tax year is March 1. But not this time. Because 2012 is a leap year, the deadline is Feb. 29. The law says you have 60 days from the start of a year to get the money into the plan. So don’t procrastinate.