While most people think that finance is boring and includes only small-nerdy-brown-socks-accountants (sorry guys!), there is a real World of Willy Wonka behind the scene. Financial magicians are working hard day after day in order to create the most powerful and smart financial strategies. As we have financial engineering taking care of financial products, we have several financials planners creating amazing personal finance techniques. Today I will outline the basic principals of the Double Dip. This may not be the official term, but I like to use this one as it appears to be a good representation of what it allows you to do. This may be they only time where double dipping is permitted!
The Double Dip was issued from a combination of two financial products. The first one is the investment loan (yet again, another leveraging strategy!) and the other one is the RRSP. Where are you dipping? And even more important, where are you double dipping? Patience, we are getting there.
A well-known advantage of the investment loan is the tax deduction related to the interest paid on the loan. In fact, The Canadian Government allow you to deduct all interest paid on a loan that was used to invest and produce an income. Therefore, you can reduce your gross earned income with your interest bill.
The same tax principle is applicable on RRSP contributions. Actually, the full amount of the contribution can be used to decrease your earned income. The only limitation you have is set at 18% of your previous year income. Keep in mind that your unused contributions can be carried forward indefinitely.
I donâ€™t know if you are seeing what is coming next but we are finally getting to the double dip strategy. Letâ€™s assume that your marginal tax rate is 40% and the interest rate on your loan is prime (6%…. for now…shoot it just has been changed yesterday for 6,25%). By signing for a 100K investment loan, you will pay $6,000 in interest each year. Therefore, your tax return associated to your investment loan will be $2,400. You net interest cost will be $3,600.
Once you have received your tax return in the mail, you take that $2,400 and make an RRSP contribution. Next yearâ€™s tax return will grow up to $3,360. Why is that? You will still have $2,400 from your investment loan deductible interest and another $960 from your $2,400 RRSP contribution. By double dipping in the Governmentâ€™s taxation laws, your net interest cost after one year will be $2,640.
Therefore, you are reducing your interest rate risk related to the investment loan while building a RRSP account that could benefit from tax deferment. If you keep on double dipping, your tax return will increase along with your RRSP contribution. The only thing that will decrease is your net interest cost on your investment loan. I think we all want that! Iâ€™ll write another post with full calculation later on. In the meantime, you can ask me questions or work out some numbers.
***part 2 of the technique is now ready here!***
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