Are you mulling how much to contribute to your Registered Retirement Savings Plan (RRSP) this year and wondering if you could get a bigger return than you get from mutual funds or GICs? There might be a strategy you should consider.
For many, mutual funds are well-suited to their savings strategies. They generally provide a reasonable rate of return. However, for others, there may be an option that potentially sidesteps the risks of market volatility, increases savings, provides deductible debt and even lets you exceed your usual contribution limits. It’s complicated, so consult with your tax advisor, if you think the plan might work for you.
The strategy also allows you to take on tax deductible debt. Normally, mortgages fall into the category of debt-bearing interest that can’t be deducted from taxes. Typically, over the term of the loan, most end up paying thousands of dollars in interest to the lender. If your RRSP is large enough, you can lend its capital to yourself to finance a mortgage inside a self-directed RRSP and pay yourself that interest, which provides a healthy fixed-income return. You earn the interest as you repay the principal of the mortgage to yourself. That keeps the cash working even as it’s being paid back.
The first two steps in this strategy are:
1. Set up a self-directed RRSP, and
2. Put the mortgage into the plan.
Your self-directed RRSP may hold a mortgage on any residential or commercial property in Canada that you own, provided:
However, while the mortgage is insured, you can’t miss a payment or two even though you’re borrowing your own money. Failing to make payments means the administering financial institution could place the mortgage into default and sell the property.
Instead of using the cheapest interest rate, like the one you’d want to get from your financial institution, you can pick the posted rate because you want to pay as much interest as you can to yourself. Posted rates are generally double the current returns on guaranteed investment certificates (GICs) and non-high-yield bonds.
Let’s say you have a $200,000 mortgage and the same amount in your self-directed RRSP. The money in the plan can be used to pay off the mortgage lender and you then start making regular mortgage payments to your RRSP — in other words, to yourself.
If your mortgage is paid off, you might want to borrow $200,000 on a home equity loan and spend that money on some conservative investment that will yield a stable rate of return in a non-registered investment portfolio. You then take $200,000 from your RRSP to pay off the equity loan.
In the end, you:
So, if you set up an RRSP mortgage with a 25-year amortization period and you are paying yourself back $1,400 a month, you’ll eventually contribute $420,000 to your RRSP, more than twice what you took out.
That may result in paying more than the normal allowable RRSP contributions. Generally, your contribution limit is based on your annual income. But because your RRSP holds the mortgage, you must make those regular monthly payments into the RRSP regardless of what your annual income is.
Another point to keep in mind: If you borrow money on a home equity loan to invest outside your RRSP, the interest on that loan is tax deductible. If you borrow money to put into your RRSP, you can’t deduct the interest.
When considering holding your mortgage in a self-directed RRSP, there are several financial considerations to discuss with your tax advisor:
The longer the amortization period, the more you put into the RRSP. However, you could make your RRSP mortgage “open,” meaning you can pay it off at any time without penalty. This tactic comes at a premium rate, so you wind up paying more interest. The same applies if you create an RRSP mortgage as a second mortgage on your home.
This strategy is complex and doesn’t make financial sense for everyone. Your advisor can help you to determine if this retirement savings tactic is in your best interests.