RRSP Loan Suitability and Strategies

After discussing RRSP strategies with your clients,  you can review the following to determine their suitability for an RRSP loan and an appropriate strategy.

RRSP Loan Benefits

An RRSP loan may help your client's RRSP grow faster and repaying the loan becomes a method of forced savings. Consider the following facts:

• An RRSP contribution reduces your client's taxable earned income and in most cases results in a tax refund. Without the contribution, this is money that would have otherwise gone to the government.
• The cost of borrowing money is low (by historical standards):
• Even if the cost of the loans is higher than the return of the investment, an investment strategy funded by a loan will beat one where the contribution is funded with after-tax dollars.
• The effect of compound investment returns outweighs the cost of the loan because interest is calculated on the initial value of the investment.
• The refund can be used to partially repay the loan, helping to lower the cost of the loan.
• The sooner your client invests in an RRSP, the longer money can work, tax-deferred, within a strategic asset allocation approach.

Does your client need to �borrow to invest�? The answer may be yes when�

• Other financial demands make contributing to an RRSP difficult.
• Your client is not disciplined enough to make regular contributions throughout the year.
• There is a widening gap between required retirement funds and current projections based on invested assets.

Consider RRSP loans for a simple, reasonable alternative that can help you maximize your client�s retirement contributions and reduce their income taxes in one step.

Use a methodical approach to justify the need to borrow to reach investment objectives. But, remember that RRSP loans don't make sense in cases where your client/prospect is already carrying a lot of debt. In situations where the investor may not be able to handle the debtload, it's not a good idea to take out more debt for an RRSP loan, even if current rates are tempting.

You can deal effectively with clients'/prospects' fears and misconceptions about borrowing to invest

When recommending borrowing to contribute to RRSPs, you will find that clients/prospects often have contradictory attitudes about money:

• Their common aversion to borrowing to invest (usually due to lack of proper information).
• Their fear of not having enough money to retire.

A wariness of playing the market with borrowed money vies with the feeling that your client can't retire well without participating in the capital markets.

Here is how to approach your clients:

• Instead of making a small contribution this year or letting room from previous years go unused, your clients can maximize their RRSP contributions and get a large amount of money compounding tax-free until they retire.
• A loan provides the potential for tax refund, (which sensible RRSP borrowers will use to pay down their loans and lower their total borrowing costs).
• Interest rate trends pointing to a long-lasting environment of low interest rates.

Examples: Mike plans to contribute $6,000 to his RRSP this year.

Here are several options to present to Mike:

(Mike's marginal tax bracket is 40% and his tax refund with a $6,000 contribution could be $2,400.)

Reinvest refund:

By simply reinvesting his refund into his RRSP, Mike may increase his annual contribution by 40% from $6,000 to $8,400.

Gross-up refund:

Recommend Mike borrow $4,000 to increase his contribution to $10,000. In a 40% tax bracket, this may produce a refund of $4,000, which is used the pay the whole loan.

Mike's contribution grew by 67% while taking a loan for only a short period of time, which demands a negligible amount of interest.

Here is how you calculate the total contribution produced by the gross-up approach: after-tax amount divided by (1-the individual marginal tax rate).

Top-up loan

Recommend Mike borrow $8,500 to maximize his annual RRSP contribution by using a short-term loan to finance the contribution. In this instance, his annual contribution will be $14,500, or 142% greater than his original planned $6,000 contribution. In the 40% tax bracket, this may produce a potential refund of $5,800, leaving $2,700 to be carried on the loan.

Catch-up RRSP Loan

This strategy generally produces a larger retirement fund, even when investment returns are lower than the interest rate on the loan, and enforces the discipline to repay the loan.

Let's compare a "Catch-up strategy" with one where no loan is used. Mike is in the 40% tax bracket and has $20,000 of unused RRSP contribution room available. He decides to take a $20,000 RRSP catch-up loan which will allow him to reduce his taxable income and may result in an $8,000 refund which can immediately reduce the loan to $12,000. With a 7% non-deductible interest expense, the $12,000 can be paid off over 10 years with annual payments of $1,597.

Joan will make regular investments equal to Mike's loan payments, but will spend the tax refund.

Grace will make regular investments equal to Mike's loan payments and will reinvest the tax refund.

*current cost of borrowing to invest is 4.5% (as at September 2005)
**before tax returns

The table summarizes the RRSP value for each strategy after 10 years. By borrowing to invest, Mike is ahead of Joan and Grace in every scenario that assumes a positive annual rate of return. While both Joan and Grace are to be commended for making regular contributions to their RRSPs, often neither strategy beats borrowing to invest because the initial investment is substantially higher. Note that when investment returns match or exceed the interest rate on the loan, the catch-up strategy is always as good as or better than not using a long-term RRSP loan.

3. Ensure your clients borrow within their means
Affordability is a key issue in determining whether an RRSP loan is a good idea for a client. Pay as much attention to the dollar amount of the monthly payments on a loan as to the interest rate of the loan. A multi-year loan using the tax refund to pay down the loan can help widen the gap between investment return and cost of borrowing.

Emphasize that the current trend of low interest rates makes carrying the interest cost affordable. Interest rates remain low on a historical basis.

Keep in mind, the longer the term of the loan, the higher the interest rates. One way to reduce your client's monthly payment is to spread the term of the loan for longer than one year. However, this typically results in higher interest rates, too. Encourage clients to pay off their RRSP loan as quickly as possible.

4. Be ready to offer segregated funds or Guaranteed Investment Products. While your clients will pay slightly higher MERs, the guarantees afforded by segregated funds limit the risk of a leverage strategy. If the investment is in a loss position at the maturity date or upon the death of the annuitant, the guaranteed return of the original investment amount means that only interest has been paid on loan, if there is a 100% guarantee. Guaranteed investment products provide a fixed interest rate for a specified term and can provide a great balance of rate of return with security.

5. Use the tax refund to pay down the loan
Rather than taking the tax refund and spending it, clients should pay down or pay off their loan.

Some institutions will set up the RRSP loan with a deferred payment period. For example, B2B Trust's RRSP Loan Program offers a 90-day deferral period where your clients do not have to make any payments for 90 days. This program gives them the time to get their tax refund and pay off the loan before having to make any payments.

Sales Strategies

Approach for the "Under 50 segment"
Some people think RRSP loans are only for those close to retirement who are trying to "catch-up". In reality, RRSP loans can offer even greater value for younger people who have the advantage of time. It's simple – the larger the investment and the longer a client invested, the greater his or her returns will be through compounding over time.

Approach for the "Over 50 segment"
As the time to retirement shortens, it's important for your clients to contribute as much as possible to their RRSP. That's where an RRSP loan can help them make the most of their retirement plan. This is especially important if they haven't had the opportunity to contribute as much as they may have wanted to or needed to in past years. It's simple - an RRSP loan can increase their contribution now, and their tax refund can be used to either pay down a portion of the loan or used for next year's RRSP contribution.

Investment strategies
Once your clients have made the commitment to borrow to invest, ensure that you recommend an asset mix to maximize the upside potential and minimize the risk of investment losses.