Ten years ago this week, Bank of Nova Scotia introduced the idea of mass marketing multi-year RRSP catch-up loans. Branch staff at various banks previously did these loans only as custom arrangements, without any promotion. Now, virtually every financial institution offers catch-up loans, as do many mutual fund companies and dealers.

There is no shortage of potential borrowers. Statistics Canada says no more than 10% of the total RRSP contribution room available for each of the past few years got used. In 2004, only about 30% of eligible tax filers made contributions, and they used just $28.8 billion of some $360 billion in available room. There might be growing interest as boomers move through their 40s and 50s, historically the prime savings years. The baby boom ran from 1946 to 1966 and, with immigrants included, peaked in 1961.

Multi-year loans amortize large catch-ups through affordable monthly payments. Cut-rate deals are common for clients investing in a lender’s mutual funds or those of a strategic partner. Perhaps most important, a catch-up loan imposes discipline because the loan payments must be made.

The first loan payment is usually deferred for up to three months. Although unpaid interest is added to the outstanding balance, this provides time to receive the RRSP tax refund so the borrower can use it to pay down the loan.

But there are disadvantages.

First, there is an arbitrage issue — the spread between the loan rate and the RRSP’s return. This is not usually considered a big deal if the loan is repaid within one year. Any short-term loss is a small price for long-term tax-sheltered compound growth. But it can matter if the loan runs for years. Unlike regular investment borrowing, the interest is not tax-deductible. So an RRSP should earn at least 6% to justify a 6% loan.

Second, an RRSP loan counts as part of the borrower’s debt load and might affect his or her ability to borrow for other purposes.

Third, a large catch-up loan is not necessarily tax-efficient. To estimate the RRSP tax savings, advisors and Web-based calculators normally multiply the contribution by a client’s marginal tax rate. But that assumes the entire contribution fits into this top tax bracket. Often it doesn’t, especially when it’s large.

Consider Pat, a British Columbia resident with $85,000 in 2006 taxable income. His marginal tax rate is 39.7%. Let’s say Pat has $30,000 in available contribution room. A $30,000 contribution would save $11,910 in taxes, according to the standard rule of thumb — $30,000 multiplied by 39.7%. In fact (as shown in the table, “Less than meets the eye”), the full deduction would drive income down through four brackets, only about one-quarter of the money would save taxes at 39.7% and the refund would be almost $1,500 less than the rule-of-thumb projection.

Pat could maximize the taxes saved by claiming the deduction over two or more years. But that would spread out the refund and reduce the interest-saving impact of using the refund to pay down the loan.

Is there a catch-up strategy that can overcome these concerns and also work for those who simply don’t want to go into debt? Yes: a monthly investment program using an automated bank transfer — commonly called pre-authorized chequing, or PAC — can offer more flexibility, more efficient use of the tax deduction, no additional debt burden and potentially higher accumulation — all at no additional net cost. So, let’s call it the “catch-up PAC.”

First, determine the monthly payment for the catch-up loan. Use this amount instead for a monthly RRSP contribution, increasing it by the value of the related RRSP tax deduction.

If Pat borrowed $30,000 at 6% amortized over five years, the month-ly payment would be $579.98. So, there’s $580 available for the monthly catch-up PAC. Twelve contributions would reduce taxable income for the year by $6,960. With Pat’s taxable income at $85,000, the full deduction would fit into the 39.7% bracket. But, hopefully, Pat will contribute even more in coming years to use newly created room. So, let’s leave space by using the rate for the next bracket down — 37.7%.

The gross-up calculation is simple. Subtract 0.377 from 1 to get 0.623. Divide $580 by that to get $930.98. So, instead of doing the catch-up loan, Pat could contribute $931 a month to the catch-up PAC — $580 from the forgone loan payment plus $351 in tax savings.

@page_break@The tax savings can be obtained up front by reducing the taxes withheld from Pat’s paycheque. (Submit Form T1213 to the Canada Revenue Agency. Quebec residents should also send Form TP-1016 to Revenu Québec.)

If Pat’s tax account is in good order, CRA officials will calculate the anticipated tax savings and authorize Pat’s employer to reduce withholdings by that amount for the rest of the year. This may take eight weeks to get in place, so Pat could be out of pocket for the first two monthly contributions. If that’s a problem, start the PAC at $580 and boost it when the authorization takes effect.

The “Lump-sum loan vs PACing” table (above) summarizes how the two strategies compare.

We’ve made two assumptions that favour the catch-up loan. First, we assumed Pat did not defer any loan payments and, by electronically filing his 2006 tax return, got the $10,430 refund in time to add it to his second loan payment. Second, we based the PAC’s tax savings on a rate lower than the one that would really apply.

But this “fudge factor” still might not provide enough space for new contributions during the catch-up period. So, depending on the size of those contributions, part or all of the new tax savings might be based on lower rates.

The loan scenario uses no tax bracket space in the second and third years, so deductions for new contributions would start at the top rate. Applying the refund to the loan accelerated the five-year repayment to slightly more than three years. Pat’s cost was $32,042 in principal and interest, minus $10,430 in tax savings. That amounts to $21,612. Assuming average annual growth of 7%, the $30,000 borrowed is worth $37,168 within Pat’s RRSP once the loan is cleared.

The catch-up PAC contributions totalled slightly less than $34,691, with tax savings providing almost $13,079. That puts the out-of-pocket cost at $21,612 — the same as the loan’s. But, assuming the same 7% growth, this strategy accumulated $38,874 — an extra $1,706.

The catch-up PAC costs the same, but produces more growth because money goes to the RRSP instead of loan interest, and because there are additional tax savings that get invested. The terminal values are, however, sensitive to the performance assumption, as the loan invests more money sooner. The PAC would still win at a 10% growth rate, but not at 11%. Only hindsight can tell us if the market trend was such that the loan’s lump-sum deployment was better or worse than the PAC’s averaging.

Flexibility might be the biggest positive — or negative. Loan payments must be made, while PAC contributions can be reduced or suspended if there’s a financial crunch. So, the catch-up loan imposes discipline, while the catch-up PAC requires it. IE



Bruce Cohen is co-author of The Pension Puzzle, a retirement planning guide for pension plan and group RRSPs members. The third edition will be published next month.