With RRSPs at the forefront of everyone’s minds, I want to share with you my comments to one of the most common RRSP debates.
Debate #1: Is it better to pay down my mortgage or contribute to the RRSP?”
Generally speaking, either financial strategy is a good choice. It is better than spending the money on things that have no inherent financial value. It is also better than “investing” (I use that term loosely) in depreciable assets like cars.
Let’s compare the financial benefit of the two alternatives. First, let’s look at the mortgage. Let’s assume that mortgage rates are 7%. You might think that paying down the mortgage means that you forego paying 7% in the future and therefor the mortgage paydown has a financial benefit of 7%. Most mortgages are not tax deductible thus you must earn more than a dollar to pay down a dollar of debt. In fact, you probably need to earn about $1.50 to pay down a dollar of debt. Thus paying down the mortgage has an after-tax benefit of over 10%. Remember the higher the interest rate on the mortgage, the more attractive it is to pay down the mortgage.
Now let’s look at the RRSP. Even if you are in the lowest marginal tax rate, you will save around 25% in tax* (combined federal and provincial). In a higher tax bracket, the RRSP might save you as much as 46% in tax savings. The bottom line is when you compare the two; a dollar put toward the mortgage saves you 10% in interest while the RRSP saves you at least 25% in tax. Given the choice, I would take a 25% saving over a 10% saving.
The final point in favour of the RRSP is that making the RRSP contribution may give you the opportunity to both invest in RRSPs and pay down the mortgage.
For example, let’s assume I have $10,000 and I am in a 40% marginal tax rate. By contributing to the RRSP, I should save $4,000 in taxes and potentially get that in a refund. Once I get the refund, I should then take the $4,000 and pay down the mortgage. I have created $14,000 out of $10,000, $10,000 went to the RRSP and instead of paying the government $4,000, I put it to the loan.
Tax rates may vary from province to province.
Debate #2: Is it better to invest outside the RRSP than inside the RRSP?
In 2000, the capital gains inclusion rate was reduced from 75% to 50%, making investing outside the RRSP more attractive. However, is it attractive enough to ignore the benefits of the RRSP?
The two key advantages to the RRSP are (a) the tax deduction and (b) the tax deferred growth. These two benefits make the RRSP one of the most attractive financial planning tools available to Canadians. However, when you pull the money out of the RRSP, you will get taxed. Every dollar you pull out of an RRSP regardless of whether it is capital gains, interest, dividends or your original invested capital gets taxed at your current marginal tax rate.
On the other hand, the non-RRSP is taxed only on growth, dividends and interest. Withdrawing your capital is not subject to taxation. Astute investors will look for investments that generate capital gains because of the preferred tax treatment.
What’s the best solution? It depends on your personal situation but most people will still benefit from the RRSP. Let’s take a look at some key factors:
- Investing behavior. If you are a really active investor and you like to buy and sell, trade or rebalance a portfolio frequently, you may be better off with the RRSP. Outside the RRSP, everytime you trade, you create a potential tax disposition. The tax-deferred growth in the RRSP may be in your best interest.
- Time horizon. Generally speaking, it is rare to see investors hold the same investment for twenty to thirty years (or even ten years). The longer the time horizon, the more you will benefit from tax deferred compounding in the RRSP. It has been said that compound interest is the eighth wonder of the world.
- Marginal tax rates. It is important to understand what tax rate you are in at the time of the deposit but also know the your tax rate at the time of the withdrawal. This will be easier to estimate the closer you are to retirement. The worst situation to be in is if you take the money out in a higher tax bracket than when you put the money in.
- Investment flexibility and freedom. RRSPs have some investment restrictions especially in terms of the foreign content limits. Outside the RRSP, there are little to no restrictions of what you can do. While there is still lots of investment flexibility inside the RRSP, there is more outside the RRSP.
- Overall financial picture. There is such a thing as having too much RRSPs. In some cases, your RRSPs may be so significant that your future income from the RRSP will push you into a higher tax bracket. In other situations, deferral of the RRSP can create a very significant tax liability down the road.
Remember everyone’s situation is different and you must take the time to assess your personal situation to see what path is best for you. My comments are general statements that may not apply to everyone.