Reinvesting tax refunds is a painless way to improve RRSP positions

Reinvesting a tax refund into an RRSP could represent the extra bump that helps clients reach their ultimate financial goal, says John Yanchus, a tax and estate planning consultant with Canada Life.

“Many people view a tax refund as a windfall at tax time,” Yanchus said. “Now, I don’t want to take away anyone’s shopping spree, but [reinvesting the refund] may be a way to boost your retirement plan.”

Tax refunds can also play a key part in a strategy known as the “gross-up” strategy, which involves calculating an RRSP loan sufficient to result in a refund that would entirely pay off the loan.

Yanchus said the gross-up formula itself is not difficult, but it does require a clear view of the client’s contribution plans and their marginal tax rate.

“The formula for the gross-up amount to borrow is your RRSP contribution amount, times your marginal rate, all divided by 1 minus your marginal tax rate,” he explained.

By way of example, a person with a 40% marginal tax rate who is able to contribute $5,000 would first calculate their expected tax refund ($5,000 times 40% = $2,000). Then they would divide the $2,000 refund by one minus the tax rate (in this case, 0.6) for a total of $3,333. This is the amount they would borrow, adding it to the original contribution of $5,000. The total $8,333 contribution will generate a tax refund sufficient to pay the $3,333 borrowed.

“This refund will fully repay the loan required for the additional contribution and really should only be outstanding for a couple of months,” he said. “It actually is fairly straightforward but pretty amazing when you can put that into place.”

In general, borrowing money to top up RRSPs can benefit clients in the long run. Yanchus said in addition to allowing clients to use up more of their RRSP room and catch up on missed contributions, RRSP loans have the added benefit of being more front-of-mind.

“In human psychology, it may be easy not to make regular RRSP contributions, but it is not easy to miss a loan payment,” he said.

The refund generated by the contribution can help repay the loan or serve as yet another RRSP contribution. As for the interest due on the loan, Yanchus said that market appreciation often covers the payments.

“While the rate of return of an RRSP is important, I would suggest the length of time invested and the compounding of the rate of return over multiple years would far outweigh interest paid in the short term,” he said.

However, “any interest paid on an RRSP loan is non-deductible for income tax purposes,” Yanchus said.

Although the topic of retirement can be awkward for some clients, Yanchus said they generally get over that when the conversation turns to their ultimate financial goals and their vision of how they want to spend their golden years.

“It becomes a little easier when we focus on certain elements, mainly the goals and desires,” he said. “If we can focus on achieving the goals and desires, I think the path begins to illuminate and makes it a little easier to plan how to get there.”

He said unique ideas, concepts and strategies tend to arise as clients start thinking about the specifics of their retirement.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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