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RRSPs: sound insulation for your money house

It’s that time of year when we make the decision whether or not to make a registered retirement savings plan contribution. From Mr. Money’s perspective, RRSP deposits are a smart start to saving for the future that allow you to get a tax refund from the Canada Revenue Agency, potentially begin developing good credit habits and provide sound insulation to your money house.

If you are unsure of how much you can contribute, the CRA will have provided you the exact amount that you can contribute this year when they mailed you a notice of assessment last spring.

Building RRSP contribution room is easy and can begin at an early age. Those summer jobs in high school can be a great start.

Yes, it does mean that your son or daughter has to complete a tax return, another great learning opportunity, but they more than likely won’t have to pay any tax because their income will be less than the personal credits that can be claimed. More important is the fact that 18 per cent of all earned income can be used in future years, when they are in higher tax brackets, to reduce taxable income. Not to mention the tax-deferred compounding.

For example, if Mr. Money’s son or daughter earns $8,000 each summer from age 16 to 18, and files a tax return each year, they will begin to build RRSP contribution room of $1,440 annually. If they invest these contributions at just five per cent, by their 30th birthday they will have accumulated $8,559. Left to compound to their 60th birthday, that amount will have accumulated to almost $37,000.

If tax had to be paid on the interest earned, the deposit would only accumulate to slightly better than half that amount, or $19,921.

Our friend Mr. Money advocates soundly insulating your money house from the impact of income taxes, and an RRSP deposit is good insulation indeed.

If you do not have access to ready cash, you may want to consult your credit union or bank financial adviser to see if an RRSP loan fits your financial plan. They are a low-cost way of ensuring that you take advantage of your allowed RRSP room, reduce your total taxes owing and allow you to start earning tax-deferred income immediately.

RRSP loans can be amortized for up to 24 months, but sound financial planning practice is to pay them off in 12 months so as to minimize interest expenses and ensure that you have adequate cash flow to fund future loan payments or other household needs.

For example, a $5,000 RRSP loan, assuming a rate of 4.75 per cent, would result in $128 of interest expense if paid off over 12 months. Borrowing $5,000 to fund an RRSP deposit, assuming you are in the 32 per cent tax bracket, would potentially earn you up to a $1,600 tax refund. You can then use this refund to pay off a portion of the loan, effectively paying off the remainder of the loan in nine months, assuming your first three months payments are interest only.

The RRSP deposit, invested at five per cent over 25 years, would result in almost $17,000 to fund retirement.

For young people just starting out, RRSP loans are a much better alternative over credit cards or other unsecured loans to develop credit history. Demonstrating to a financial adviser or loan officer wise borrowing decisions will go a long way towards getting approved for that first mortgage. Having a plan to build net worth can only add to the confidence of lenders.

Remember that one of Mr. Money’s principles of accumulating net worth is that moderately and sensibly borrowing to accumulate wealth is a far better personal financial strategy than borrowing for consumption. Borrowing to buy a consumable item means that once the item is used up you still have the loan to pay off.

In contrast, a good long-term investment asset can add value to your net worth, and as I tell all of my students, the goal of every rational investor is to build net worth over the long run so that you can be in control of your financial destiny.

Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’



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