When I was growing up, my grandfather told me that if something is worth doing, it's worth doing right. I think of an article last year in The New York Times reporting that finding a dentist in Britain has become so tough that in one week, over 6,000 do-it-yourself fillings and crown-and-cap replacement kits had been sold to Britons. Hmm. There have to be just a few drawbacks to doing that procedure in your basement. If it's worth doing, it's worth doing right.
When it comes to retirement savings, doing things right is critical so that you don't run out of money before running out of retirement. I wrote recently about the value of borrowing for registered retirement savings plan contributions. This is a follow-up on "doing it right" when borrowing for your RRSP.
Minimizing taxes If you're thinking about borrowing to contribute, and you happen to have non-registered investments outside your RRSP already, consider contributing some of those nonregistered investments in-kind to your RRSP. This will provide the same RRSP deduction as contributing an equal amount of cash. Then, borrow to replace those investments outside of your RRSP.
Doing this right, you'll be able to deduct the interest costs on the loan since you'll be investing outside the RRSP (you can't deduct the interest when borrowing to contribute to your RRSP). Deducting this interest will help to minimize taxes.
Keep in mind that any investments you contribute inkind to your RRSP will be deemed to have been sold at fair market value, which could trigger a capital gain, although the RRSP deduction will more than offset that capital gain if you have sufficient RRSP contribution room. Any capital loss triggered on the contribution inkind will be denied, so it makes sense to sell these losers on the open market first, then contribute the cash.
Minimizing interest If you don't have non-registered investments, or prefer not to make a contribution in-kind, borrowing to make an RRSP contribution can make sense. You may want to pay off that loan as quickly as possible to minimize the non-deductible interest costs.
Consider borrowing enough to contribute to your RRSP to create a total tax deduction that will pay off your loan entirely with your expected tax savings (which often comes back as a tax refund).
Want an example? Consider Jake: Jake contributed $5,000 of his own money to his RRSP in 2006. He wants to add to this total by borrowing to contribute more to his plan. He also wants to pay off the RRSP loan with the tax refund he's expecting to receive as a result of his RRSP contributions.
So, Jake will borrow $4,092 from his bank this month and contribute the proceeds to his RRSP, for total RRSP contributions of $9,092 deductible on his 2006 tax return. Given his marginal tax rate of 45 per cent, Jake expects a tax refund of $4,092 from these contributions - approximately the right amount to fully pay off his loan.
How did Jake figure out the amount to borrow to create tax savings that will pay off the debt? The amount of the loan should equal the amount of his own money that he contributed, divided by the following ugly formula: 1/MTR ? 1 (where MTR is his marginal tax rate). Jake's MTR is 45 per cent. So, the ugly formula provides the following result: 1 divided by 0.45 is 2.222, subtract 1 equals 1.222. Jake contributed $5,000 of his own money to his RRSP for 2006. So, take $5,000, divide it by 1.222, and the answer is $4,092, which is the amount Jake is going to borrow.