Your RRSP is the best way to save for retirement. Money in an RRSP grows untaxed as long as it remains in the plan. Moreover, your contributions are tax deductible. To get a deduction for the 1997 tax year, the deadline for contributions is Monday, March 2, 1998. Your maximum deductible contribution is 18 per cent of your 1996 earned income to a maximum of $13,500. From this, you must subtract any pension adjustments if you are a member of a pension plan. You can add to your contribution any missed contributions from previous years beginning with 1991.
Should You Borrow for Your RRSP?
The question many people ask themselves at this time each year is whether they should borrow money to contribute to their RRSPs. Virtually every bank and other lending institution offers RRSP loans so access to funds is no problem. The loan rate is generally at prime so the cost is not high. The big incentive, of course, is to reduce taxes now. In fact, someone with contribution room of $13,500 and a marginal tax rate of 51 per cent will save $6,885 in taxes.
But whether you should go ahead and borrow depends on your own unique situation.
You should consider your other debts, your marginal tax rate, your future income level, your ability to pay back the loan quickly, and the expected rate of return you will earn on the borrowed funds in your RRSP. If you decide against borrowing, you do not lose your contribution. You just add it to next year's and carry it forward.
Look first at your other debts. If all your credit cards are strung out to their limit, the last thing you need is additional debt. You already have difficulty making payments and an RRSP loan will likely put you in a worse position. The only debt you should be considering is a loan to consolidate your high-interest debts. Once you have these debts under control, you can consider borrowing funds to catch up on your RRSP contributions.
Consider your marginal tax rate. If you are at the low end of the spectrum at about 26 per cent, your tax savings will be minimal. That means your potential refund will cover only about one-quarter of the loan. You are probably better off waiting until your income level is higher, at which time you may have the cash to contribute, as well as a larger tax deduction from RRSP contributions.
In all cases, you should look at how you intend to repay the loan. Will your tax refund and cash flow be enough to
retire the loan within one year? In addition, will you be in a position to save the funds you need to make next year's contribution? If you see your cash flow and balance sheet improving, by all means go ahead. But if you see yourself in the same or a worse position at this time next year, you might be better off saying no to a loan. Instead, take the money you would have used to make payments each month and contribute it to a plan for 1998. You can always borrow to catch up on your unused contributions at some point in the future. Your decision should also reflect the rates of
return you expect. It makes little sense to borrow if you have major concerns about the direction of the markets near term. Alternatively, purchase money market mutual funds for your RRSP with the loan and move that money into equities as prices move lower or the future becomes less certain.
Smoke and Mirrors
Use your RRSP for what it is intended: A tax-assisted
means of saving for your retirement. Indeed, most people do just that. However, there are always some who look for a little bit extra. If you hear of a scheme that sounds too good to be true, it probably is. In fact, there have been many strategies bandied about over the years that look extremely good on paper, but can be very costly if the markets move the wrong way, especially if the scheme requires the use of borrowed funds. For example, a person might borrow $200,000 for investment purposes and use the $13,500 that might otherwise be contributed to an RRSP to pay the interest. If you earn 15 per cent a year compounded for the next five years, you will have a $200,000 profit, or about $125,000 after tax. You then contribute $67,500 to your RRSP and get a tax break (assuming you do not trigger alternative minimum tax), and you will have some cash left over. Of course, if the market fails to meet your expectations, the profits will not be as great. The worst-case scenario would be for the market to fall dramatically. Unless your loan is secured, you could be forced to liquidate or put up additional security.
TEST YOUR RRSP KNOWLEDGE
Some of the RRSP rules are complex.
Here are 10 questions to test your knowledge.
1. The last day you can have an RRSP is:
a) your 69th birthday
b) Dec. 31 of the year when you
c) Dec. 31 of the year when your spouse turns 69
d) your 71st birthday
e) the 60th day of the year follow-
ing the year when you turn 69
f) Dec. 31 of the year when you turn 71
2. RRSP contribution limits are scheduled to rise to $14,500 in:
3. You can carry forward unused RRSP
a) 1 year
b) 3 years
c) 5 years
d) 7 years
4. Which of the following investments does not qualify for your RRSP?
a) Canada Savings Bonds
b) units of a mutual fund that
invests in precious metals
c) equity call options traded on a Canadian exchange
d) equity put options traded on a
e) shares of labor sponsored
5. Which of the following statements is
a) Interest on money borrowed to make an RRSP contribution is deductible from income for tax purposes.
b) Annual RRSP trustee fees are deductible from income for tax purposes.
c) The minimum age for an RRSP is 18.
d) The minimum age for a RRIF is 60.
e) Debt issued by the InterAmerican Development Bank is RRSP-eligible without limit.
6. Which of the following statements about the Home Buyer's Plan is false?
a) You are allowed to withdraw up to $20,000 tax-free to buy or build a home.
TEST YOUR RRSP KNOWLEDGE
b) You cannot participate if you or your spouse ever owned a home in which either of you resided.
c) You must repay any funds withdrawn under the plan in no more than 15 years.
d) You may not be able to deduct contributions made to your RRSP if you withdraw funds under the plan in the subsequent 89 days.
e) You have to be a resident of Canada to receive funds under the HBP.
7. The average 10-year compound return for RRSP-eligible Canadian equity funds is approximately:
a) 20 per cent
b) 17 per cent
c) 14 per cent
d) 11 per cent
e) 8 per cent
8. Which of the following statements is true?
a) You can only make a contribution to a spousal plan if your spouse does not make a contribution that year.
b) If a spouse cashes in a spousal plan in the year in which the contribution was made, the proceeds will be paid to the contributor.
c) If a spouse cashes in a spousal plan in the year after the contribution was made, the contributor must declare the proceeds as income.
d) You can transfer your lump sum pension benefits to a spousal RRSP.
e) Only the contributor may determine what investments are made for a spousal plan.
9. When your RRSP matures you can:
a) cash it in and pay tax on the proceeds
b) transfer the proceeds to an RRIF
c) purchase a life annuity issued by
an insurance company
d) purchase a term annuity that provides payments that must end before age 90.
e) a, b, c and d
10. Your maximum RRSP contribution is based on your earned income in the previous year. Earned income excludes:
a) dividend income
b) net rental income
e) a, b, c and d
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Your Last-Minute RRSP
Do not leave making your RRSP contribution until Monday, March 2. You might have some difficulty getting the level of advice you need. However, if you have not made your 1997 contribution yet, do not make any investment decisions until you have all the information you need. Your best RRSP investment for the last minute is either an RRSP-eligible money-market fund or an RRSP-eligible savings account with a financial institution. In both cases you will get an investment that is virtually risk-free. And you will meet your objective of getting a tax deferral. Once you have met the deadline you can investigate your options when you have more time and move the money into something that better suits your long-term needs.
Your choice of moneymarket fund or savings account
should be based on convenience, cost and return. Return, of course, is important. But if you intend to move the money within a few weeks, even a few percentage points difference in annual rate will be insignificant in terms of dollars earned over the period. The reality is that you will be lucky to earn
one per cent in a savings account, so look at that as a convenient way of getting a tax receipt and nothing more.
If you intend to move the money into the stock market directly, you can contribute the cash to your self-directed RRSP. You will almost certainly earn some interest on the cash balance. Similarly, if you own mutual funds in your RRSP, you can contribute the cash to your plan and earn interest, or purchase units of a money-market fund. You should be able to buy the units of the money-market fund at zero commission. Depending on what arrangements you have with the dealer, you may pay a commission when you move that cash into growth or income funds.
If you choose to put the money in the bank, you should be aware that bank charges vary widely. In most cases, however, the charges are not significant. For example, most-but not all-institutions will charge about $25 for a full or partial withdrawal or a transfer to another institution. That fee may be waived if you use the money to purchase another type of RRSP asset offered by the first institution.
Several institutions offer reduced fees or interest rate bonuses for seniors. Most calculate interest based on the daily closing balance, and compound it monthly or semi-annually. A few compound interest annually. The compounding period can make a very slight difference in your earnings. Rates paid often depend on the amount of money left on deposit.
You are protected if the financial institution, dealer or fund management company should ever run into difficulty. RRSP deposits with banks and trust companies are covered by deposit insurance up to $60,000 in principal and interest per institution. Cash left in an investment-dealer-sponsored self-directed plan is covered up to $60,000 by the Canadian Investor Protection Fund. Mutual fund assets are kept separate from a fund management company's assets and are held by a custodian. ■
Steven G. Kelman
Steven G. Kelman is the author of RRSPs 1998 and Understanding Mutual Funds, and co-author of Sage Advice: Choosing the best financial adviser for you.
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