The number one question Canadians are asking this RRSP season is whether to pay down debt before contributing to their long-term savings, says Jamie Golombek, CIBC’s managing director of tax and estate planning.
“While Canadians’ current views are shifting towards debt reduction, this strategy may not necessarily make sense for everyone,” he says.
Golombek’s new report, The RRSP, the TFSA and the Mortgage: Making the Best Choice, illustrates the various factors Canadians need to consider when making an informed decision on this question—a decision complicated by increasing household debt, a low interest rate environment, and the introduction of the TFSA.
To maximize savings, the report recommends considering five key factors:
- The expected rate of return on your investments
- The interest rate on your debt
- Your current and anticipated personal tax rates
- Your time horizon
- Investment risk
“Factoring in these five key points can help you save thousands over the long term. It’s not about making the perfect decision. No matter the outcome, you will still be ahead of the game whether you choose to invest in an RRSP or TFSA or to repay debt, because you are saving for your future.”
An example
Suppose Amy has $1,500 of pre-tax earnings that isn’t needed to pay her monthly bills; a current income tax rate of 33.33%; and an expected rate of 20% at retirement.
After paying $500 (33.33% x $1,500) in current income tax, she’ll be left with $1,000 of after-tax cash flow that can be used to either invest in a TFSA or make an additional repayment against her mortgage.
Alternatively, she could contribute the entire $1,500 to her RRSP and pay no tax until the time of withdrawal. Suppose that over the long term, she expects an average 5% rate of return (ROR) on her equity-based investments and has a mortgage with a 3% interest rate.
The chart below calculates the increase in her net worth under each of the three options.
Benefit after one year from RRSP, TFSA and debt repayment
(ROR = 5%, Interest rate on debt = 3%, Tax rate today = 33.33%, Tax rate upon withdrawal = 20%)
| RRSP | TFSA | Debt | |
|---|---|---|---|
| Income subject to tax | $1,500 | $1,500 | $1,500 |
| Income tax (33.33%) | NIL | (500) | (500) |
| Plan contribution / debt repayment | $1,500 | $1,000 | $1,000 |
| Income earned (5%) | 75 | 50 | n/a |
| Interest saved (3%) | n/a | n/a | 30 |
| Value of benefit after one year (pre-tax) | $1,575 | $1,050 | $1,030 |
| Tax payable on withdrawal (20%) | $(315) | NIL | N/A |
| Benefit after one year (after-tax) | $1,260 | $1,050 | $1,030 |
This example illustrates the impact that income tax rates, the expected rate of return on investments, and the interest rate on debt would have on her benefit after just one year.
While Amy may be assured of saving 3% interest on her mortgage while this rate is locked in, the rate of return on her investments may not be so certain. For a true comparison to the guaranteed interest savings on the mortgage, the rate of return on a risk-free investment, such as a Government of Canada bond, should also be considered.