RRSP Loans never made sense

I have now received three unsolicited solicitations (two through postal mail, one through email) for pre-approving me for an RRSP loan. The rates both institutions were offering were 3%, up to a low 5-digit dollar amount. The terms of such loans are such that you have to pay it off in a year.

The advertising always tries to grab your attention by stating that by loaning money you can get a good fraction of it back from the government when you file your income taxes and some people probably use this to rationalize making a loan. Unfortunately, the true financial value of the tax credit is worthless. I won’t get into why in this post, but some fellow wrote about it here and it is a much better way of thinking about one’s RSP than what is otherwise intuitive – his reasoning is not intuitive, but it is correct.

I have always wondered why anybody would ever bother doing an RSP loan from a rational perspective and the scenario that comes into mind deals with a high-income individual that has their cash flows so lumpy that they will only receive it after the March 1, 2010 contribution deadline and where this person’s balance sheet is in such crummy (or illiquid) shape that they cannot pull out non-taxable reserves into the RRSP umbrella. It would also imply their cash management in prior years is equally crummy since they failed to save enough money to pay for the RRSP.

Such people are likely to have high levels of debt, which highly suggests they should be putting their cash into their debt. However, in the event that their debt has a low interest rate, then the RRSP loan would make sense.

In other words, the number of people that truly need RRSP loans are next to none. I can’t fabricate a real life scenario where somebody working a full-time job would want to loan money for an RRSP.

Ever since the advent of the TFSA, the retirement savings game has changed considerably – although there are exceptions to every rule, if I had to make a “one rule fits all” criteria for RRSP vs. TFSA contributions, the math highly suggests the only people that should ever be considering to make a contribution in an RRSP are those making more than (note: 2010 year) $81,941 a year, which is where the 26% federal tax bracket kicks in. Otherwise you should contribute money to your TFSA first, and then your RRSP with any leftover amounts you have left to save.

If you make less than $81,941 a year, your first dollars should go to your TFSA and then if you have money left to save, into your RRSP. In no way should your net taxable income go below $40,970 – you can still contribute to your RRSP, but you should wait until a future year where you make more than the lowest bracket to actually deduct the income.

Taking out an RRSP loan to defer the income tax is financially foolish, especially since the interest on the loan is not tax-deductible. The only exception I would make is if you are supremely confident you will be able to make more than the loan interest on an after-tax basis (so let’s say you are in the 40% tax bracket and your RRSP loan is at 3% interest; you would need to make 3%/(1-0.4) = 5%) but I do not think this is appropriate for most and that taking an RRSP loan is functionally equivalent to borrowing money in a brokerage account to invest. The only difference between an RRSP loan and borrowing to invest on margin is that at least when you borrow to invest on margin, you can deduct interest expenses from your income tax.

6 thoughts on “RRSP Loans never made sense”

  1. Agree that RSP loans are not smart; but some people are unable to commit to any payment but a loan; so makes sense for a few that need the “demand” of a loan to finally do it. Agree any loan should be no longer than 12 months.

  2. AnniM: Thank you for your comment. I believe what you are referring to is the concept called “forced savings”.

    An RRSP loan is just leverage, and financially it is just better to loan the same amount of money outside the RRSP for investment purposes – you can then deduct interest.

  3. The complexity of this stuff is pretty brutal – I would like to believe that I am significantly more financially savvy than the average dude on the street, yet figuring out when it is better to pay down the house vs RRSP contributions vs TFSA (or some other option) is still not easy for me.

    But the relative benefits of RRSPs are crystal clear compared to RESPs – I spent about a week trying to determine if it was worth opening one (or more!) for my children. I still have no idea if they make financial sense, but the restrictions on what you can do with the proceeds of an RESP combined with poor support by financial institutions convinced me to stay the hell away.

  4. Also, you once told me that there is a specific dollar amount you don’t want to be withdrawing more than from an RRSP per year (during retirement), based on how government benefits are means tested.

    Do you have an updated version of that number?

  5. It depends on how much pension income you are planning on making. The phrase you want to search for is the “GIS clawback”. Generally speaking, you want to either make ZERO in other income, or make more than $15,700/year of non-old age security income.

    The only reason why one would want to open up an RESP is because of the 20% CESG grant, which is virtually free money, but other than that, it is equal to just giving money to your kids and deferring income taxes to your kids when they finally go to school, but it is a very long term decision to open one up for something that may or may not happen in 18 years…

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