Dateline: 1/19/98

So what's it mean to be contrarian? You see this phrase ballyhooed about so much by investment pundits who boast that they are contrarian and everyone else is not, it's sometimes hard to know what they mean. In general it means investing against the crowd. So right now when people are unloading Asian equities and selling off gold, the contrarian strategy would be to buy Asian stocks and gold.

But I think being truly contrarian means going against accepted wisdom. Conventional thinking says "Buy low and sell high." My fellow Guide at Investing (U.S.) follows a truly contrarian position. He argues that if a stock is swan diving, it's often doing so for a good reason. He suggests you should follow trends. His motto is "Buy high and sell higher." An interesting thesis and, in my opinion, a contrarian one.

Contrarian thinking is not always good advice. Conventional wisdom says you should drive on the right side of the road. You can be contrarian and drive on the left if you like, but it may prove fatal. So always assess claims of contrarianism with a grain of salt. Sometimes being contrarian is just plain dumb.

In this article I will challenge two accepted pieces of wisdom about RRSPs and saving on income tax. One is that you should buy your RRSPs as early in the taxation year as possible. The other is that RRSPs are the best way to avoid tax and increase your wealth.

Invest Early Outside Your RRSP If You Can't Max Out

Money is awfully tight in our family and though I'd like to max out my RRSPs, I haven't been able to. I just can't afford it. So to increase my tax advantage, I do my investing outside my RRSP by regular contributions from each pay cheque. Then, towards the end of February, I move those investments into my RRSP. Why would I do that?

Certainly conventional wisdom says otherwise. Garth Turner, whose 1998 RRSP Guide I am reading right now, says people are making a mistake putting money into their RRSP in February. He repeats the common wisdom that "by always making that contribution at the very end of the allowable period, instead of at the beginning, you lose an entire year in which that money could have been growing tax-free." He goes on to say, by way of example, that $3500 put into your RRSP at the beginning of the year instead of at the end will give you almost $60,000 more after 30 years at an annual compounded rate of return of 10%.

Well, Turner is right, as far as he goes. And every other advisor I've ever read says exactly the same thing. But I don't think it's sound advice unless you can afford to put the maximum amount into your RRSP during the year. If you can't, my recommendation is keep the money outside until the end of the year and then roll it in. Here's why.

Suppose you can only afford to put $1000 into your RRSP every year. You can afford to put it in at the beginning of the year. You do so. Let's say the mutual fund you invest in returns 10% on the year. At the end of the year, you have an equity value of $1100 in your RRSP and a $1000 tax deduction. You get a tax refund of $400 (assuming a 40% marginal tax rate.) Your new equity from your investment is $1500.

Now suppose that instead of putting that $1000 into your RRSP at the beginning of the year, you invest it outside the RRSP. It still grows 10%. At the end of the year you have $1100 to put into your RRSP. You have to declare a capital gain of $100 on your return, but, capital gains are taxed at a lower rate than regular income. You only have to pay tax on 75% of the capital gain or, in this case, $75. At the 40% marginal rate that is $30. But you claim a tax refund at your marginal rate on the full $1100 for a rebate of $440. Your net tax rebate is $410. You are $10 dollars further ahead with an equity of $1510. The results are charted below.

But what if you can make the maximum contribution at the beginning of the year? Should you invest inside or outside the RRSP? Clearly, in that case, the capital gain for the year cannot be added to your RRSP contribution because you will go over the limit. You will not get the additional tax refund. So it is wiser, if you can afford to max out, to put the money into your RRSP immediately. From my personal experience (and Turner confirms it in his book) few people are in a position to do this.

For the last several years I have invested outside my RRSP on a monthly basis and rolled the entire amount into my RRSP in February. This gave me a larger RRSP contribution than I could have afforded otherwise. And if you have capital losses from previous years to offset the gain (as I had), you are even better off.

There is a further question here as well. What's the beginning of the year? If you're allowed to put money into your RRSP until February 28, then the beginning of the year should be March 1. If you're just starting out making RRSP contributions and follow the conventional wisdom, you might think it is a good idea to put your money into the RRSP on March 1 in order to claim a deduction a year later. Uh uh! No way, Jose! If you can put $1000 into your RRSP on March 1, then you sure as hell can find a way to put it in a day early and get an immediate tax refund. Why wait over a year for your refund when you can get it in a few months?

The conventional wisdom is unclear and confusing on these points. Here's my advice:

1. If you can contribute the full amount of your eligible RRSP limit at the beginning of the year, make the contribution a few days earlier and claim the tax deduction in the current year. Don't wait a year. Re-invest the refund as soon as you get it.
2. If you can't make the full RRSP contribution at the beginning of the year, but can afford to put in a lump sum, still try and make it a few days early and get the refund sooner rather than later.
3. If you can't afford to max out your RRSP in one lump sum, but can afford to max out by making equal payments from each pay cheque over the year, contribute those payments directly into your RRSP.
4. If you can't afford to max out your RRSP contributions even by making regular payments from each pay cheque, invest outside of your RRSP and roll the entire amount into your RRSP in late February, gaining the difference between your tax refund and the capital gains tax paid. (25% of the gain in value).

Of course, the above is predicated on your investments gaining in value over the year. If they decline, you get a smaller RRSP deduction, but you gain a capital loss. You lose 25% of the difference instead of gaining it. If you're a pessimist about your investments gaining in value during the year, you shouldn't be investing in equities in the first place. In that case, go for interest paying investments and put them into your RRSP as early as you can since interest earned is taxed at the full rate.

What's Better Than an RRSP?

Let's go a step further than the above advice and examine a totally different alternative to the RRSP. (And I'm not talking about Limited Partnerships, Income Trusts or other fancy tax shelters.) It's based on several principles. First, capital gains tax is payable on a gain at the point of liquidation, not before. Second, many mutual funds have excellent long term track records, so a buy and hold investment strategy is easily implemented. And third, interest paid on a loan made for investment purposes is tax deductible but interest paid on a loan made to put money into an RRSP is not.

Suppose you can afford to put $1000 a year into investment, either inside an RRSP or outside of one. If you put $1000 a year into an RRSP and re-invest the tax refunds and the investment grows at a rate of 10% a year compounded, you have an investment after ten years of $23,906.14. (See chart below.) Not bad.

RRSP Investment of $1000 a Year for Ten Years, Rebates Re-invested

(Rate of Return = 10%)

Now suppose that you are able to borrow money and pay interest only on that loan. (And it is quite possible to do that, even without a home equity loan.) You borrow an amount such that the interest payments each year are $1000, the amount you would otherwise be putting into your RRSP each year. If the cost of borrowing is 10%, you can borrow $10,000. You invest that in a selection of good quality mutual funds with excellent long term and short term track records (any of my Power Performers that also have good ten year and/or fifteen year records) and hold for the long term.

Since you do not sell the funds, they compound tax free, just as they would do in an RRSP. Since the interest is tax deductible, you get the same tax refund as you would with an RRSP. Again, you re-invest the tax rebates. Will this strategy put you further ahead after ten years?

If your rate of return is 10% and your cost of borrowing is also 10%, your portfolio is worth $31,369.22 after ten years. But you still owe $10,000 to the bank, so your equity is $21,369. With those rates, you are better off putting the money in an RRSP every year.

But, in fact, those are not the current rates. You can get rates as low as prime right now if you put up the equity in your home. (I know because I am currently doing just that. And I am required to pay only interest.) Without collateral other than the mutual funds themselves, you can borrow at rates as low as prime plus one percent amortized over 16 years. Currently that is 7%. And if you put up a minimum of $5000, you can borrow double that and pay interest only at prime plus 1.5%. (Send me a note if you want to know where you can get these terms.)

Let's look at a loan at 7%. You have several options. You can borrow more than $10,000 such that your annual interest payments are still $1000 a year. Then you would be borrowing $14,285. At the end of ten years, you would have a net equity after deducting the outstanding loan balance of $28,198, about $4300 more than you would have in an RRSP.

Another option is to borrow exactly $10,000 again. Since you are willing to invest $1000 a year and since the interest payment is only $700, you invest an additional $300 a year on top of the re-invested tax refund. That scenario gives you a net equity after ten years of $24,520, about $600 more than you would have in an RRSP. Although this strategy doesn't have the payoff that investing $14,285 has, you do have a buffer in case interest rates go up.

But we are looking at returns of only 10%. The average return for all Canadian equity funds over ten years is 10.4%. The average for all U.S. equity funds over ten years is 14.3% The average for all International funds is 8.7% This includes all the clunkers and dogs. Surely an astute investor can find a mix of funds to return at least 12%, perhaps even 15%

At 12% return, the RRSP portfolio is worth $26,674 after ten years. At 15% it is worth $31,471.

By contrast, the $10,000 portfolio on borrowed money with a lending rate of 10% and a return of 12% is worth $26,968 net after ten years. If the lending rate is 7% the portfolio is worth $30,460.

And if you can get a 15% return, then the portfolio borrowed at 10% is worth $37,169. If the portfolio is borrowed at 7%, then it is worth $41,247 net after ten years. In virtually all realistic scenarios, the non-RRSP portfolio is worth substantially more. And the differential is as much as $10,000 or 1/3 of the value of the RRSP portfolio. The exception is if the rate of return is equal to or less than the cost of borrowing.

Of course, the longer you hold the portfolio, the greater the differential, as the extra money after ten years continues to compound. Below is a chart showing the investment outside the RRSP borrowed at 8% with a return of 12% with additional investments each year in the amount the interest payments fall short of $1000.

Non-RRSP Borrowed Investment of $10,000 with Tax Rebates Re-invested

(Interest rate = 8%, rate of return = 12%)

If you can get a locked-in rate for ten years, you should borrow such that your interest payments equal the amount you would otherwise put in an RRSP. This puts a lot more money to work for you right away.

Here is a short table of the advantages and disadvantages of an RRSP versus a leveraged non-RRSP portfolio.

The biggest drawbacks to the Leveraged Non-RRSP method is its lack of flexibility and problems with income splitting and bequest. There may be ways around this with trusts and corporate holding companies or even joint ownership. Check with a lawyer and/or accountant.

There is another way you can benefit additionally from the Non-RRSP leveraged investment. Investing this way allows your RRSP eligible contribution limit to grow. If the government doesn't change the carry-over rules, you can, after a few years, decide to fold the entire portfolio into your RRSP (after settling the outstanding principal.) You pay tax on the capital gain at 75% of your maximum rate and deduct the RRSP contribution for a 100% tax deduction.

In our example charted above, you have a $29,296 tax deduction. At a 40% marginal tax rate, that will net you about a $3000 refund net of capital gains tax.

If you borrowed a larger amount so that your interest payments were the same as you would have put into the RRSP, you make an even greater tax saving than you otherwise would. You get the same amount of tax savings from your interest payments that you would have gotten from the RRSPcontribution, plus you get an additional 25% of that tax savings when you roll it into your RRSP. Neat eh?

I should point out one caveat at this point. Strictly speaking, the Income Tax Guide says "you can usually deduct the interest paid on money you borrowed to earn investment income (such as interest or dividends, but not including capital gains)." What does this mean in practice? Clearly we are going for capital gains here. But equity mutual funds do sometimes pay dividends which are then re-invested. You are required to report those dividends every year and pay tax on them. Those dividends are then deducted from the totals when you cash out, as you've already paid the tax.

The big question is, will Revenue Canada disallow the interest payment deductions because you are primarily seeking capital gains? In practice, I believe they cannot. How can they tell whether you're investing for the gains or the dividends? They can't! But if you're worried about that, discuss it with a tax advisor.

I'm interested to hear your comments on my strategies. Is my math right? Did I goof? Or is this a sound alternative to investing in RRSPs? Place your comments in our new Bulletin Board area. I look forward to reading them.

Changes to Investing (Canada)

The Investing (Canada) Bulletin Board is here! Here's your chance to speak out, ask questions, seek advice, offer advice, and generally have a great old time. I'm looking forward to lively and thought provoking discussions.

We have a Chat room, but so far the traffic has been pretty sparse. If you want to chat live with myself about anything, send me an email and we can arrange a mutually convenient time.

Next week:

Hey, hey, hey! It's Monthly Mutuals time again! We'll check out the latest reports and see how our portfolios are doing.

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