Contributing to your RRSP is a great thing, but an RRSP loan isn’t always the best way to do it.
Around this time of year you’ll start seeing banks promoting the idea of RRSP loans, where you borrow money to make an RRSP contribution. If you have no cash available, and if an RRSP contribution is a good option for you, it can be tempting. But consider carefully before taking them up on their offer.
RRSPs reduce your taxes by sheltering income from tax when you contribute. You will pay the income tax later when you withdraw the funds, which is ideally when they’ve had a few years to grow (tax-free), and when you’re in a lower tax bracket because you’re retired or pulling back from your career.
A Tax Refund Isn’t Guaranteed
Banks promote RRSP loans based on the idea that your RRSP contribution gets you a refund that you can use to repay the loan. Sounds great…except there is no guarantee that you’ll actually get a refund.
Tax refunds occur when the amount of tax that has been withheld from your income throughout the year exceeds the amount of tax you end up owing when you do your return. Even though an RRSP contribution will almost always bring down your tax owing, it isn’t necessarily going to bring your tax bill low enough to create a refund.
For example, if your income is low or your employer has not been withholding (enough) tax throughout the year, your refund might be small or non-existent. If your refund doesn’t cover the loan, you’ll have to find the money to repay the loan and any interest.
And remember: an RRSP contribution doesn’t earn you back the same amount in tax reduction. At most you’ll get back 30-50% back in tax, and have to pay the rest of the loan some other way.
The Cycle Begins, The Bank Wins
Ideally, you should be contributing to your RRSP throughout the year, not just at the last minute. The first 60 days of the year should be for some final top-ups, not the main process by which you make contributions.
The problem with getting an RRSP loan instead of contributing through the year is that you can end up spending the following year paying off the loan rather than contributing. Or you use your refund to repay the bank, instead of using it to start the next year’s RRSP contribution. When the next RRSP season rolls around you’ll have no money to contribute – again – and you’ll have to get another loan.
When a Loan Makes Sense
If you absolutely need to make an RRSP contribution, for example, if you had a bump of income that you need to shelter from tax, and for some reason you don’t have the cash available in time to meet the contribution deadline, then taking out an RRSP loan can be a good option. But it should be an occasional thing, not an annual event.
For the most part it’s always best to set money aside ahead of time or make RRSP contributions during the year than to get into a cycle of borrowing money and paying interest every year. If you come into RRSP season with cash available to contribute to your RRSP without taking out an RRSP loan, you’ll save on bank interest and you’ll have the remainder of the year to save for next RRSP season.
