Income tax time is here again and that means every financial planner and his dog are trying to sell you some RRSP (401K or IRA in the US) to help reduced your income tax bill. Why people wait till the start of 2007 to buy a RRSP for 2006 is really beyond me but if you are in this group, here is a trick you can do to get the most out of your Registered Retirement Savings Plan (RRSP) contribution.
Putting The Refund To Work
When you buy a RRSP, you trigger a tax refund equal to the marginal tax percentage of your contribution. For example, if you were in the 40% tax bracket, a $10,000 RRSP contribution will give you a $4,000 tax refund. If you were in the 50% tax bracket, you’ll get $5,000 back. Most people spend their tax refunds on butter when what they should be doing is putting that refund back into the RRSP. How do you do that?
Before I show you the steps, I have to say this will only work for someone who has not maximized their RRSP contribution to the limit ($18,000 or 18% of 2006 income, whichever is less). The majority of Canadian (and I suspect Americans as well) do not maximize their registered retirement savings accounts because they do not have the needed funds. Here is a way to get a lot more money into your RRSP at almost zero cost.
Let’s assume you are in the 40% tax bracket and have $10,000 to invest into a RRSP. What you do is go to your bank and make a RRSP loan for $6,666.67, add in your $10,000 and buy $16,666.67 of RRSP investments. This will trigger a tax refund of $6,666.67 ($16,666.67 X 40%) which you will use to pay back the bank. Your cost will be 1 to 2 months of interest at most (interest on RRSP loans are not tax deductible). This kind of loan is extremely safe for the banks (they know they’ll be paid back with the tax refund) and they will give it to you below Prime.
With the above strategy, you no longer have a tax refund (well, you do but it’s going to the bank) but you increased the funds you put into your RRSP by a huge amount. This will make an amazing different at retirement time. $10,000 a year into a RRSP at 8% for 20 years will turn into $494,229.21. However, $16,666.67 invested at 8% for 20 years will turn into $823,715.52.
The formula on how much you can borrow so the tax refund matches the RRSP loan is:
Amount available to invest divided by 1 minus your marginal tax rate.
In the above example, it’s $10,000/(1-0.4)=$16,666.67
Many people take their RRSP tax refund and use it to help pay down their mortgage. However, I advise doing that only after you’ve maximized your RRSP contribution. If the above investor were to put $10K into his RRSP he would receive a $4,000 refund to use against his mortgage. That gives him a total investment of $14,000 vs. $16,666.67. More money working for you is always better. On the other hand, if the investor already has enough to maximize his RRSP, then the refund should definitely go to paying down a mortgage.
The Proper Way To Invest In a RRSP
Most people buy their RRSP around this time of the year because it’s tax time. Financial planners and banks sell the RRSP as a way to reduce taxable income and get a tax refund. When your work place deducts taxes from your paycheck, they do so based on the assumption that you will not be buying any RRSP investments – this is why you get a tax refund. If your employer deducts from you paycheck based on you buying a RRSP, they would not withhold as much – that gives more money in your pocket from each paycheck. How can you make your employer do this? By buying your 2007 RRSP now instead of in 2008.
Some people may not know this, but RRSP investments are available for purchase anytime of the year. You don’t have to wait till tax time to buy it. Say you buy $10,000 of 2007 RRSP at the start of year and you’re in the 40% tax bracket. That will trigger a $4,000 tax refund when you file your 2007 tax return in 2008. However, you can take this RRSP receipt to the Canada Revenue Agency and get a letter from them that tells your employer to make source deductions based on your gross income less the amount of your RRSP contribution. This will give you about $334 extra per month ($4,000 divide by 12). When tax time comes in 2008, you will have no refund and you will get an extra year of tax-free RRSP growth because you brought the RRSP in the beginning of 2007 instead of 2008.
Getting a tax refund means YOU OVERPAID YOUR TAXES! It is the stupidest thing you can do! If you get a tax refund, it means you loan YOUR MONEY to the government for a whole year INTEREST FREE! The amazing thing is, most people are happy to get a tax refund! When someone tells me they’re getting XXXX amount back in a tax refund, I say, “I’m sorry to hear that.”
If you just brought your 2006 RRSP and don’t have any money to buy your 2007 RRSP, then borrow the money from your bank to buy it. Take the RRSP receipt to get the Canada Revenue Agency letter and use the extra money you get from each paycheck to help pay back the loan. This is how you make the system work for you, instead of against you.