Jack and Jill came to me regarding their financial situation. They have been married and working for the past three years and last year bought their first home together. They had a bunch of questions about various issues regarding taxes, insurance, retirement and investing.
One of the most interesting issues came from the fact that they had about $500 per month of excess income and were hoping to get some direction on what to do with that cashflow.
We did a financial plan for them to help them deal with their extra cashflow. From a retirement perspective, they needed to invest about $800 per month to achieve their retirement goals. They were already saving about $400 per month through a Group RRSP plan at work which included employer matching. With $500 per month of extra cashflow, saving for retirement seemed very realistic.
We then discussed four options for their monthly cashflow:
Pay down the mortgage.
Their mortgage interest rate was 4.5%. On the surface, any lump sum contributions to their mortgage principal means an interest savings of 4.5%. However, if you consider that to pay one dollar to the mortgage means that you must earn more than a dollar because of taxes. The pre-tax benefit of putting money to the mortgage is actually a savings of 6.6%. If you could find a GIC paying 6.6%, would you buy that GIC? As you can see, paying down debt can be a great investment.
Related article: How to pay down your mortgages faster
Invest monthly into the RRSP.
The benefit of the RRSP is that Jack and Jill would get an immediate tax deduction and they get tax deferred growth inside the RRSP. If Jack and Jill put $500 into the RRSP, they will get an immediate tax savings of about 32% ($160). If we compare this to the mortgage pay down, they would be better off in the short term by buying the RRSP (32%) than paying down the mortgage (6.6%). In fact, the ideal situation is to buy the RRSP and then put the tax refund towards the mortgage.
Related Article: Everything you need to know about RRSPs
Invest monthly into a TFSA (Tax Free Savings Account).
Up to this point, Jack and Jill have not put any money into TFSAs mostly because they did not really understand the benefits.
Related article: Understanding the basics of TFSAs
Putting money into the TFSA will not give them a tax deduction like the RRSP. However, any future growth in the plan and any withdrawal’s from the TFSA are tax free (Remember that RRSPs are not tax free but simply provide a tax deferral). TFSAs are great for retirement savings but they are also great for all kinds of savings needs. The flexibility makes the TFSA very attractive. So which is better for Jack and Jill? Comparing the TFSA vs the RRSP is not always an easy comparison to make.
Related Article: TFSA vs RRSP: The new debate
Invest monthly into non-RRSP.
Until they have maximized the TFSA, non-RRSP savings or investing does not make a lot of sense. Also, paying down debt may be a better investment than investing into non-RRSP savings or investments.
RESPs are not far away.
Jack and Jill want to start a family in the near future and as a result want to also put money into RESPs. Given Jill may go on Maternity leave within the next few years, the TFSA has added appeal because they can access that money before retirement with no tax.
For now, RESPs are not an option but when they become an option, the government will give them 20 cents in a grant for every dollar they contribute into the RESP (up to a maximum of $2500 per year). If you compare this 20% return to a 32% immediate return from the tax deduction from RRSP contributions, you might argue that RRSPs are better. However, it’s not a perfect comparison either because the savings goal or need is very different. One (RESP) is for the child and their education while the other account (RRSP) is for the parents retirement.
Related article: RESP contribution rules
My five cents
I used the example of Jack and Jill to help you to understand some of the different options ahead of you for your money. It is important to keep in mind that your personal situation is likely to be very different than that of Jack and Jill.
Remember that it is not an all or none situation for these savings options. For Jack and Jill, they decided that they would contribute $200 extra to the RRSP for the long term as long as their incomes were higher than the 32% marginal tax rate. Their tax saving would be used to pay down the mortgage unless they thought the markets could produce future returns of 7% or more.
Jack and Jill really wanted to start up savings to the TFSA as well so they allocated the remaining $300 per month to the TFSA. This would give them flexibility to put it to a lump sum on their mortgage, top up the RRSP or use it towards RESPs in the future.
If you need help deciding what is best for you, it may be wise to consult a financial advisor.