How you invest in RRSPs, especially what you do with your income tax refund is an often-overlooked practice that has a huge impact on the size of your retirement funds. In this section, we identify five RRSP refund strategies, each producing different levels of retirement income.
As you can see in the chart, each refund strategy defines a different path that an investor can take. The path chosen depends on the individual’s human nature and commitment to their financial goals.
For illustration purposes only
To illustrate, let’s say that Melissa has $1,000 to invest and is in a 50 per cent tax bracket.
- Strategy # 1: Spend your refund
- Strategy # 2: Contribute your refund to your RRSP
- Strategy # 3: Gross-up
- Strategy # 4: Top-up
- Strategy # 5: Catch-up
Strategy # 1 – Spend your refund
Unfortunately, the most common strategy is to spend your income tax refund. If your primary goal is to maximize retirement income, you must recognize that if the refund is spent, it produces absolutely no retirement benefit. The $500 tax deduction that Melissa receives for contributing $1,000 to an RRSP reduces her after-tax cost from $1,000 to $500. Therefore, if she spends the refund, Melissa’s after-tax commitment to her retirement goal is only $500.
Strategy # 2 – Contribute your refund to your RRSP
As a disciplined investor, Melissa knows that to get more benefits from her RRSP, she must contribute all of the refund back into the RRSP. Simply contributing the 20 to 50 per cent tax refund increases your RRSP funds by the same 20 to 50 per cent.
By contributing the $500 refund, Melissa’s RRSP starts at $1,500 instead of $1,000 – an increase of 50 per cent. But there are several ways Melissa can do even better.
Strategy # 3 – Gross-up
Melissa can borrow an extra $1,000 to “gross-up” her RRSP contribution to $2,000. The $1,000 refund is used to immediately repay the $1,000 loan so she pays little, if any, interest. By “grossing-up”, Melissa gets the maximum RRSP dollars working for each dollar she has to invest. For someone in the 50 per cent tax bracket, this approach grosses-up $1,000 into a $2,000 RRSP contribution.
NOTE: The “grossed-up” strategy results in no loan outstanding and is different than the following two strategies where a larger loan is paid off over one or more years.
Strategy # 4 – Top-up
Traditional RRSP loans are promoted to “top-up” RRSPs to make the maximum annual contribution possible. If Melissa’s RRSP room for the year was $5,000 and she only had $1,000, she could borrow the extra $4,000. Her refund could pay off a significant portion of the loan.
Strategy # 5 – Catch-up
In the last few years, some institutions have promoted larger RRSP loans that can be used to “catch-up” all unused RRSP contribution room at once. This is an extension of the “top-up” strategy, but the loan is paid off over several years.
The last two cases are a conservative form of leverage, or borrowing money to invest. While the interest expense is not deductible when you invest borrowed funds into an RRSP, you get a bigger deduction and a much larger RRSP growing earlier.
Tax refunds or credits that are spent effectively increase your current standard of living at the expense of your retirement. If your investment priority is retirement, the income tax refund should be put towards that goal. Reinvesting the refund or using an RRSP loan is a simple way to increase your RRSP funds by 20 to 50 per cent or more.