In a high interest environment, RRSP loans must be considered very carefully.panida wijitpanya/iStockPhoto / Getty Images
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A registered retirement savings plan (RRSP) loan used to be seen as a great escape strategy for late contributors – a way to defer a large tax bill at the eleventh hour.
But unless RRSP loans are paid off with the ensuing tax refund, they can become a big problem, especially in the current interest rate environment, says Lindsay Sparrow, senior investment advisor with Sparrow Wealth and Professional Services at Wellington-Altus Private Wealth Inc. in Edmonton. That’s because interest on RRSP loans is usually 7.45 per cent or higher for terms ranging from three months to three years.
“For the average Canadian, instead of applying [their tax refund] to the loan, they go on a trip,” Ms. Sparrow says. “It becomes very hard to get out of that cycle.”
It’s why advisors advise clients to be diligent about paying off the loan – or avoiding it altogether.
“At some point, you hit a wall – you’re just paying all that interest,” says Benoit Peloquin, president and portfolio manager at Exponent Investment Management in Ottawa.
When it’s a good idea
Ideally, RRSP contributions should be made throughout the year through automated withdrawals to avoid last-minute panic, says Brenda Hiscock, an advice-only certified financial planner at Objective Financial Partners Inc. in Cobourg, Ont.
But there are some situations when clients might want to consider a loan.
When a client pays it off right away
RRSP loans can be a good idea for the most diligent of investors – the ones who dutifully pay off their entire loan, or at least most of it, with their tax refund, Ms. Hiscock says.
When a client is having a banner year
She adds an RRSP loan can also be a great tool for those who contribute in a high-income year, when they’re in a higher tax bracket, as they’ll get a significant tax break. At retirement, when they withdraw funds from the RRSP, they’ll likely be in a lower tax bracket, so this strategy reduces the taxes paid over their lifetime.
RRSP loans can therefore be especially beneficial for employees who earn commission or bonuses and have those earnings deferred, augmenting their income in a given year, says Mr. Peloquin.
When a client is saving for a home
If a client is saving a down payment for a home, Ms. Sparrow says, then an RRSP loan may help them to get there faster. First of all, they’ll get a tax refund for their RRSP contribution. Second, the Home Buyers’ Plan (HBP) allows them to take up to $35,000 out of an RRSP to put down on a first home – so topping it up can get them that mortgage, and home, more quickly. The money borrowed for the HBP must be in the RRSP for at least 90 days before it’s taken out.
When it’s not a good idea
The client is not a disciplined investor
Leaving RRSP contributions to the last minute doesn’t usually go hand in hand with paying off loans in full, Ms. Sparrow of Wellington-Altus says.
So, those considering a loan in late February this year should think twice.
“People who aren’t disciplined generally aren’t going to pay off that loan right away,” she says.
Ms. Sparrow says that for those who continue to pay off the loan for years to come, it can be financially draining to have monthly loan payments that are in the hundreds of dollars. And carrying an RRSP loan can prevent people from making additional RRSP contributions for years to come.
The client is a lower-income earner
If a client is earning a lower income, the income at retirement might not be that different than what they’re earning now. In these cases, Mr. Peloquin suggests saving for retirement in a tax-free savings account (TFSA).
The RRSP funds won’t grow much
RRSP contributions should be invested in a vehicle in which those assets can grow, such as mutual funds, exchange-traded funds, stocks or bonds, Ms. Sparrow says. She advises investors visit a financial institution that offers a variety of investment options within an RRSP.
“Otherwise you’ll end up with a [guaranteed investment certificate (GIC)] and if it’s in GICs, it may not be worth it,” she says.
All in all, RRSP loans should be weighed carefully, factoring in income, one’s financial habits and the cost/benefit, Mr. Peloquin says.
Once you’ve taken out a loan, “the meter is running at that point,” he says.
So, if a client is pondering an RRSP loan, knowing they’re not an ideal candidate, Mr. Peloquin advises they “wait a year, get out in front of their finances and contribute monthly next year.”
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