Home Buyer's Plan

Anyone know which of these two positions is right? My dad and I are debating this point...

Scenario - recent grad, 21K in RRSPS, bought house primarily with borrowed money. In year house was bought, 10K in tuition + 35K employment income. Income in future years will be, in all likelihood, 90K, 110K, 130K, and so on.

Issue? whether the recent grad should have used the Home Buyer's Plan to withdraw 20K tax free repayable over 15 years.

I'm guessing no since it makes sense to get taxed on the 20K at a relatively low marginal rate right now instead of paying it back over the next 15 years out of after tax dollars taxed at a high marginal rate. (*edit* I mean no, don't use the HBP, but simply withdraw all of the RRSP money and get taxed on it upfront)

My dad says its more important to keep the RRSP limit up (or something like that). That its more tax upfront, but in the long run, it works out.

I'll be honest, I don't know RRSPs that well. Anyone know if there's an obvious answer?

Originally Posted by Icedawn

Issue? whether the recent grad should have used the Home Buyer's Plan to withdraw 20K tax free repayable over 15 years.

I'm guessing no since it makes sense to get taxed on the 20K at a relatively low marginal rate right now instead of paying it back over the next 15 years out of after tax dollars taxed at a high marginal rate.

I'm not sure I follow what you are asking.

Assuming you *didn't* use the 20k from your RRSP towards the home, you still owe the 20k, just to the bank instead of the government so not only will it still be coming out of your after tax income, you'll also be paying interest on it.

I'd say, who cares. Within several years, this guy is going to have 200K salary, a couple of thousand in taxes is peanuts. I surely hope the 21K RRSP is not claimed though.

Also, this guy's income is going to be taxed anyway. It doesn't matter whether he uses it to repay HBP or buys expensive toys.

Originally Posted by tomincanada

....you still owe the 20k, just to the bank instead of the government so not only will it still be coming out of your after tax income, you'll also be paying interest on it.

Thats exactly it. You will be paying the 20K off your mortgage with after tax dollars. However, a large portion will be going towards interest. Had you used the 20K from the HBP, you would still pay it back with after tax dollars, but you would have 20K off the principal of the house.

Congrats on landing a nearly 6 figure income right out of school! Almost 20% raises to start is also amazing.... where are you working? Are they hiring? LOL

-John

I'm still confused.

I see 3 options, which ones are you debating between?

1. Leave the RRSP where it is. Don't use it at all the buy the house.
2. Withdraw the RRSP, but NOT under the HBP, pay the taxes on the withdrawl.
3. Use the RRSP to buy the home under the HBP. No taxes to be paid.

Option 1 seems silly unless you are making a lot of money off of that RSP. You are better off using money you have than paying the bank interest.
Option 3 is a better solution than 2 as you get the money to use now (less mortgage), don't pay the taxes and keep the RSP space. The only drawback is that you do have to pay that RSP money back, but sometimes forced RSP savings aren't a bad thing.

The salary thing has come up before... some professions obviously start at these types of numbers.

In particular, my buddy from school followed option 3 as Sockboy described it. When I heard about it, I thought option 2 was better.

And interesting, I see what you mean Sockboy. But what's he paying in tax? Won't he only have to pay ~20% tax on the 20K of RRSP withdrawals, meaning 4K of tax versus 9K of tax he'll pay later?

So yeah, its only 5K difference, but still?

(just for clarity, debating between option 2 and 3, we do agree option 1 would be silly)

Originally Posted by Icedawn

The salary thing has come up before... some professions obviously start at these types of numbers.

In particular, my buddy from school followed option 3 as Sockboy described it. When I heard about it, I thought option 2 was better.

And interesting, I see what you mean Sockboy. But what's he paying in tax? Won't he only have to pay ~20% tax on the 20K of RRSP withdrawals, meaning 4K of tax versus 9K of tax he'll pay later?

So yeah, its only 5K difference, but still?

(just for clarity, debating between option 2 and 3, we do agree option 1 would be silly)

How would he avoid the 9K taxes with option 2?

Originally Posted by Archanfel

How would he avoid the 9K taxes with option 2?

well, this is where my confusion comes from since I don't know RRSPs that well.

Option 3 - 20K withdrawal. 0% tax. $0K tax. lets use an easier number and assume repayment over 10 years. That means $2k/year repayment from after tax dollars. Assuming ~45% marginal tax rate, requires $3600 pre-tax dollars a year. So in summary, after 10 years of using up $3600/year of pre-tax dollars, he'll end up with 20K of capital in his RRSP account.

Option 2 - 20K withdrawal. 20% tax. $4k tax payable upfront. Left with 16K. And $4K loan. However, to make it a fair comparison, what happens if he uses up the same $3600/year of pre-tax dollars. To repay the $4k loan at, say, 6% in 10 years means ~$600 a year. Pre-tax thats $1090. Leaving $2500/year of pre-tax dollars which can all be contributed tax free to his RRSP. Meaning, after 10 years of using up $3600/year of pre-tax dollars, he'll have 25K in his RRSP account.

Yeah... so that's sorta what my gut told me in the car that my dad thinks is wrong. What am I missing? My dad claims its a failure to accomodate for decreased deduction limits for option 2, but I'll be honest, I'm not quite sure where to take that into account.

The problem is that you are assuming that the guy has the room to contribute $2500 more. Giving the salary projection, he probably wouldn't, which means the $2500 is still taxed at 45% and he lost $20,000 RRSP room + interests payment.

A couple of things in addition to Archanfel's point.

Would this individual really remain in the bottom tax bracket after adding 20k of income? 35k + 20k=55k. Even with 10k in tuition I am guessing that some of that 20k would be at a higher rate.

You are sort of making the argument that he never should have claimed his RSPs in the first place. (Unless he was making big bucks prior to going to school). Which I would agree with, but now the RRSP room has been used it changes the picture somewhat.

Lost RRSP room is something that has a much higher percieved value with age. I used the HBP myself. I had more than 20k in RRSPs and considered withdrawing another 5k (paying the taxes) to use towards a larger downpayment. With my tax rate it seemed to make sense. But after talking to my Dad (good 'ol Dad eh?), he really stressed that RSP space is limited, and to loose it is a big deal. When you are just starting out you tend to have piles of RSP space, but as you get older, save more, make more and pay more tax, it runs out quickly. The real advantage of an RRSP is the protected investment income. Loosing 20k of principle space is a lot of potential investment income.

Originally Posted by Icedawn

Anyone know which of these two positions is right? My dad and I are debating this point...

Scenario - recent grad, 21K in RRSPS, bought house primarily with borrowed money. In year house was bought, 10K in tuition + 35K employment income. Income in future years will be, in all likelihood, 90K, 110K, 130K, and so on.

Issue? whether the recent grad should have used the Home Buyer's Plan to withdraw 20K tax free repayable over 15 years.

I'm guessing no since it makes sense to get taxed on the 20K at a relatively low marginal rate right now instead of paying it back over the next 15 years out of after tax dollars taxed at a high marginal rate. (*edit* I mean no, don't use the HBP, but simply withdraw all of the RRSP money and get taxed on it upfront)

My dad says its more important to keep the RRSP limit up (or something like that). That its more tax upfront, but in the long run, it works out.

I'll be honest, I don't know RRSPs that well. Anyone know if there's an obvious answer?

You didn't mention how much that '20K' is making inside the RSP.

Originally Posted by Icedawn

My dad says its more important to keep the RRSP limit up (or something like that). That its more tax upfront, but in the long run, it works out.

I'll be honest, I don't know RRSPs that well. Anyone know if there's an obvious answer?

That $20k is compounding tax-free inside the RRSP. That's what makes it such a great deal.

When you earn income, you also earn contribution room into the RRSP. But if you contribute and then withdraw, the contribution room is lost forever. THAT is what your dad is talking about.

But when you borrow from RRSP, you maintain the option to put the money back ... the contribution room is still there.

if the person has a long time til retirement, then the option that maximizes contribution room is a no-brainer. Especially if you're going to spend several years in a high tax bracket. e.g. if you're in 40% tax bracket... your RRSP is earning 8%, it's like having a 13.5% investment outside your rrsp.

Let's assume he makes full contributions to his RRSP each year he is working.

HBP: $20k withdrawal, $0 in tax paid. Repayment of $2,000 per year for ten years in addition to maximum contributions. At the end of a decade, he will have paid off the $20k in debt to his RRSP and accumulated contributions for ten years and investment income. He will also have $28,973 in registered investments from the repayment of the $20k, assuming an 8% return.

Cash-out: $20k withdrawal, $4k in tax paid. Repayment of $4,000 of debt at 5% over 10 years (assuming it will be retired in its entirety for a fair comparison) will cost $508 per year, so compared to the HBP, he will have $1,492 per year in free cash flow. His RRSP will be equal to his accumulated contributions and investment income thereon, which he had under the HBP as well. He will have $21,614 in unregistered investments from the $1500 per year (assuming an 8% return), but he will have paid tax on $6,614 in income over the course of the decade (probably running him around $3,000).

So, in conclusion, regardless of investment rate projections, the principles underlying the analysis remain the same. The HBP allows one to accumulate a greater amount of investments (because no initial tax payment is required) and do so under a registered plan, while cashing out requires one to forfeit that contribution room, contribute less to one's investments (because of the repayment of the $4k loan) and hold those investments outside the RRSP tax shelter. Over the long term, that could mean forfeiting quite a bit of potential investment income.

I'm surprised nobody has mentioned the option of having his RRSP lend him the money as a mortgage !

Originally Posted by Archanfel

The problem is that you are assuming that the guy has the room to contribute $2500 more. Giving the salary projection, he probably wouldn't, which means the $2500 is still taxed at 45% and he lost $20,000 RRSP room + interests payment.

Hm, true. No idea how good of a saver this guy is and whether he'll max it out.

Originally Posted by sockboy

Lost RRSP room is something that has a much higher percieved value with age. I used the HBP myself. I had more than 20k in RRSPs and considered withdrawing another 5k (paying the taxes) to use towards a larger downpayment. With my tax rate it seemed to make sense. But after talking to my Dad (good 'ol Dad eh?), he really stressed that RSP space is limited, and to loose it is a big deal. When you are just starting out you tend to have piles of RSP space, but as you get older, save more, make more and pay more tax, it runs out quickly. The real advantage of an RRSP is the protected investment income. Loosing 20k of principle space is a lot of potential investment income.

Originally Posted by grant

if the person has a long time til retirement, then the option that maximizes contribution room is a no-brainer. Especially if you're going to spend several years in a high tax bracket. e.g. if you're in 40% tax bracket... your RRSP is earning 8%, it's like having a 13.5% investment outside your rrsp.

Hm, that's basically what my dad said. hmm, so you're saying the long term tax benefits on the income generated by an extra 20K in the account is better than saving 4K of tax upfront? Lemme see, assuming ~30% as a compromise between dividend, capital gains, and straight income, 4K of tax = ~14K of income. Estimating 7% return on the 20K, that means it'd take 10 years for the long term benefit to be realized. <-- this sort of calculation?

Originally Posted by Icedawn

Hm, that's basically what my dad said. hmm, so you're saying the long term tax benefits on the income generated by an extra 20K in the account is better than saving 4K of tax upfront? Lemme see, assuming ~30% as a compromise between dividend, capital gains, and straight income, 4K of tax = ~14K of income. Estimating 7% return on the 20K, that means it'd take 10 years for the long term benefit to be realized. <-- this sort of calculation?

I think you're mistaken, you'll pay taxes if you WITHDRAW from the rrsp.

If you get a HBP plan, you don't pay taxes.

So withdrawing from your RRSP is a double-losing proposition:
1) you have to pay taxes immediately
2) you permanently lose the ability to have a portion of your investment compound tax free