February 7, 2008, 7:46 am

Mix your RRSP contribution with an investment loan

by: The Financial Blogger    Category: Leveraging Strategies,RRSP
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I’ve been playing with RRSP numbers for a while to find how ones can maximize his free cash flow into a great investment plan. In this post, I am comparing 3 strategies requiring the same cash flow.

Let’s say that Peter has $300 per month that he would like to invest. The borrowing rate is 7%, the expected yield is 8% and his investment horizon is 30 years. He also has a marginal tax rate of 40%.

Option #1: Full RRSP contribution

If Peter would to invest $300 a month over a period of 30 years, he would end up with $450,088. Over that period, we would also receive the sum of $1440 in tax return every year. If he would to invest this sum in a non-registered account, he would create an additional $176,178. However, Peter must keep in mind that he will have to pay taxes on the 450K in RRSP at the time of withdrawal. The marginal tax rate will be much lower on his non-registered investment.

Option #2: RRSP contribution plus an investment loan

At a borrowing rate of 7%, Peter would be able to borrow 30K to invest and his monthly payment (interest only) would be of $175 per month. Therefore, he would still get $125 to invest into his RRSP each year. This strategy would bring $301,879 in non-registered investments (including the 30K loan) and $187,536 in RRSP. This brings us to a total of $459,416 once we pay the investment loan. In Canada, the interest paid on an investment loan is tax deductible, therefore, Peter would receive again the same $1,440 that could be invested the same way as option #1. You may think that the whole strategy doesn’t really worth it as it creates only an additional 9K. However, you have to take into consideration that you have $301K sitting into a non-registered account.

Option #3: Registered and non-registered contribution

If Peter doesn’t believe in leverage strategies and still wants non-registered investment, he could invest $175 per month into a non-registered account and $125 into his RRSP. This would give him $450,088 but with much less tax return per year ($600 instead of $1440).

I would like to get back to option #1 and #2 one last time. Imagine that Peter’s marginal tax rate on his RRSP withdrawal his still 40% and 25% (capital gains, dividend, interest income mixed together) on his non-registered investment. If he would to cash in all his investment in one shot, the option #1 would give him $402,186 (450K*60% + 176K*75%) while option #2 would give him $448,565 ((301K-30K)*75% + 176K*75% + 187K*60%). Therefore, a small 30K investment loan would increase your net investment by 45K. This is the magic behind all the different ways of using your cash flow!

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How many people will actually collapse the RRSP in one shot if it has that amount in there anyway? In this case it would be converted to an RRIF or some other similar vehicle and paid out over 10 years or so. If you keep all of your fixed income investments inside the RRSP and all of your capital gains and dividends out. That makes the whole scenario fairly tax efficient. With a spouse the RRIF income could also be split as pension income.

Plus, if you’re in a 40% tax bracket, you’ve got to be making 75K+ a year. If he can only put away 300 bucks a month he’s only putting away 4.8% of his salary. Since the ‘golden rule of saving’ is to put away 10% of your income to retire wealthy, he’s really falling short. That’s going to be one rude awakening when they retire and have to severely cut back on their lifestyle.

by: The Financial Blogger | February 8th, 2008 (8:17 am)

You are right by saying that most people will probably not withdraw their RRSP contribution in one shot. However, if you only have RRSP investments, you will not be able to withdraw 100K to buy a vacation property or a rental property. Having non-registered will allow you more flexibility.