If you had and extra dollar, what would you do with it? What if it were an extra $10,000 or $100,000? Would you be the type of person that is inclined to pay down your mortgage? Or are you the risk taker who would invest in a long shot penny stock? Would you top up your RRSPs? Or would you prefer to buy Registered Education Plans for your kids or grandkids? Maybe you are like most people who will just spend any extra cash you have.
From a financial perspective, the answer is really quite simple but it requires some knowledge of what your marginal tax bracket is. Once you have your tax rate, you can weigh out your options and calculate where you will get the best bang for your buck.
Let’s look at this from the perspective of Tony who is in the 32% marginal tax bracket. Tony has come into an extra $5000 and wants to know what to do with it.
1. Invest in RRSPs. Generally speaking, the tax deduction you get from RRSPs makes this one of the best investments. Tony will save 32 cents in taxes for every dollar they invest in RRSPs. That equates to an immediate 32% return. It’s tough to argue against a 32% return.
2. Pay off high interest debt like credit cards. Tony has a VISA where he pays 18% interest. Remember that for every dollar Tony pays in interest, he must earn at least $1.47 because he must pay tax on every dollar we earn. High interest debt at 18% or more is really costing Tony 26% or more. It is really crucial for good financial planning to avoid keeping balances on credit cards with high rates of interest. Look at alternative low interest products for debt.
3. Pay off non-deductible debt. Most forms of debt are non-deductible because non-deductible debt is debt where you cannot write off the interest. For example, Tony has a mortgage where he is paying 5%. While that may seem low, Tony is paying more than he thinks. Consider that a 5% mortgage today is the equivalent of about 7.35% after tax because we must pay interest with after-tax dollars.
4. Invest in non-RRSP investments. Paying down debts might be better than investing in non-RRSP investment s depending on what you think you can earn on investing. With interest rates creeping higher, debt becomes more expensive creating a higher return requirement on the investment. In Tony’s case if he cannot earn 7.35% after tax on his investment, he is better off paying down his 5% mortgage.
5. Pay down Deductible Debt. Not all debt is bad debt. When used properly, borrowing money for productive uses like investing or business allows for the interest on the loan to be tax deductible. For example, Let’s say Tony borrowed on his Line of Credit at 7%, and used the money to invest in mutual funds. Although the interest on the loan is 7%, it really only costs his about 4.76%. Paying down this line of credit would only benefit him 4.76%.
At the end of the day, doing any of these things will be good productive uses of extra money. However, as you can see, there are clearly better and worse things. The principle here deals with effective use of cashflow whether you are talking about an extra dollar or an extra $100,000.
Tony’s situation gives you some perspective on how to figure out where you should put extra cash. Keep in mind that everyone has unique circumstances and you should consult a financial advisor for a detailed review of your personal situation.