Should you take out a big RRSP loan to take advantage of the unused contribution room you've built up over the years?

Confirmed by personal savings rates of under 2%, most Canadians don't maximize their RRSP every year, and have accumulated $193 billion of unused contribution room. So does it make sense to borrow to "catch up" most or all of your unused RRSP contribution room that just seems to get bigger every year?

"In almost all cases, the answer is yes," says Talbot Stevens, a London, Ontario-based financial educator, speaker and author of Financial Freedom Without Sacrifice.

Even when investment returns are lower than the interest expense on the RRSP loan, the "catch up" RRSP strategy will generally produce a larger retirement fund because the loan forces a higher level of commitment. Once started, the loan becomes a forced savings plan. The approach also automatically invests before-tax dollars by eliminating the human nature temptation to spend the refund that normally occurs when a "catch up" loan is not used.

The most common RRSP refund strategy is to spend the refund, perhaps on a summer vacation. Those more committed to their retirement goals might reinvest all of the refund back into their RRSP. A third approach is what Stevens calls a "gross up" RRSP refund strategy. Someone in a 50% tax bracket with a $1,000 to invest could temporarily borrow an extra $1,000 to "gross up" their RRSP contribution to $2,000. The $1,000 refund from the $2,000 contribution could immediately and completely repay the $1,000 loan.

Thus, the third refund strategy is to "gross up" the refund and invest true before-tax dollars and get the maximum RRSP contribution per dollar available to invest, without maintaining an RRSP loan. It also occurs whenever there is not a refund, which can be achieved by adjusting your withholding taxes.

The fourth RRSP refund strategy is using an RRSP loan to "top up" your annual contribution. These loans are small and normally paid off within a year. The fifth is using a larger "catch up" loan that might take 10 years to repay.

Let's say that Sue is well into the 40% tax bracket and has $20,000 of unused RRSP contribution room available. If she gets a $20,000 RRSP "catch up" loan, she will get an $8,000 refund which can immediately reduce the loan to $12,000. With an 8% non-deductible interest expense, the $12,000 can be paid off over 10 years with annual payments of $1,656.

Paying $1,656 a year for 10 years to pay off the remaining $12,000 of the $20,000 "catch up" loan can be compared to having the same cashflow invested in RRSPs where the refund is spent, reinvested, or grossed up. The following table summarizes the RRSP value for each strategy after 10 years.

When investment returns match or exceed the interest expense on the RRSP loan, the "catch up" strategy is as good as or better than not using a big loan to boost your RRSP. You can benefit from the leverage effect that occurs when returns exceed the cost of borrowing. If your returns average 10% and your interest expense is 8%, 10 years later the "catch up" strategy would increase your RRSP by 79% for those who spend their refunds, and 7% better than the best "grossed up" approach.

Even if returns are lower than the cost of borrowing, the "catch up" loan is still worth considering because it forces a higher level of commitment to the individual's retirement goal. While Sue may intend to reinvest or gross up her refunds obtained from contributing to her RRSP every year for 10 years, the loan locks in her commitment. Once started, the loan becomes a forced savings plan that generally results in more RRSP value than even if every penny of every refund was reinvested - and very few people do that.

"Each RRSP refund strategy essentially equates to different levels of commitment to your retirement goal," says Stevens. "Financial success is dependent on not just choosing efficient strategies. Often, the commitment level is the most important factor in the size of your retirement fund. The real benefit of the "catch up" loan strategy is the forced higher level of commitment that produces a larger RRSP fund in almost all cases, even when returns are below the cost of borrowing."

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Talbot Stevens is a financial educator, industry consultant, and author of "Financial Freedom Without Sacrifice" and "Dispelling the Myths of Borrowing to Invest". For other story ideas, visit the Free Resources menu of www.TalbotStevens.com. For more information, contact Judy Culford, Communications Director for Talbot Stevens, by calling (519) 663-2252, or emailing judy@TalbotStevens.com.