It’s February, so the advertising about contributing to your RRSP is ramping up. Four years ago, I wrote about the classic debate of paying down your mortgage vs contributing to an RRSP. Back then I made the bold statement that most people should be working to pay down their mortgage ahead of building their RRSP. I wanted to take this opportunity to look back and see where I was right and where I was wrong; and, also look at the problem from a slightly different angle this time around.
First, what was my answer in January 2014? I told readers to pay down their mortgage until it was at a ‘reasonable’ level so that they could stand a shock of rising interest rates. I said that the illiquidity of RRSPs made them a poor form of emergency funding should someone’s mortgage payments rise.
So, what has happened in four years? Well my unscientific analysis of interest rates using my favourite research tool, Google, reveals that mortgage interest rates haven’t changed much since the end of 2013 and depending on the term has hovered between 2.5% and 5.0%. Over the same four years the TSX Composite was up about 34% or just over 7.5% a year. That means I was wrong to some degree. For most people, if they spent the last four years throwing extra cash in their RRSP and not paying down their mortgage, they would be ahead in total net worth, under the assumption that their marginal tax rate when they pull the money out of their RRSP will be no greater than their marginal tax rate when they made the contributions. I know, nerdy technical.
But I was also right to some degree – because having money locked up in an RRSP only helps if you can delay taking it out to until you experience that lower tax rate expected in retirement. At the same time, if you have been making minimum payments on your mortgage then you still carry the risk of higher monthly payments if interest rates keep going up between today and the day you need to renew your mortgage. Part of my advice was about risk management – not leaving yourself too exposed to future increases in interest rates by carrying too much debt. I haven’t studied the new mortgage rules but it seems to me that borrowers right on the maximum debt line may have some problems when it is time to renew.
But all of this isn’t my focus today, it is just the background to my new thoughts. What I have come up with is that for most Canadians, the right choice isn’t the mortgage or the RRSP. It is the TFSA. For review, the TFSA (Tax-Free Savings Account) is where you can stash your money so that the investment income attracts no tax (like the RRSP) but where you make ‘after-tax’ contributions rather than the RRSP which involves ‘pre-tax’ contributions (and hence the tax refund).
Why the TFSA? Two big reasons: First, when you take the money out there is no tax to pay on either the capital that you contributed or the income that you earned on the money. Second, you can take the money out of a TFSA any time and regenerate contribution room to re-contribute later. That isn’t true for RRSPs, once you take the money out there is no adjustment to be able to put more in later.
What this means is that if you contribute to the TFSA in this low interest rate world and the investments you select do well compared to the interest you pay on your mortgage then you will be always be ahead in terms on total net-worth compared to the safer choice of paying down the mortgage regardless of how your marginal tax rate changes. But here is the big difference: if interest rates move against you in the future and that puts you in a pinch, you can pull the money from the TFSA to soften the blow of higher mortgage payments without any immediate tax hit and without losing the ability to replenish those savings.
One of the big selling points of the RRSP is to save when you are making the ‘big bucks’ to get a tax deduction at the higher marginal rates and then take the money out after you have stopped working when presumably you will be taxed at lower rates.
But if you are 25 and just starting your career, you might not yet be at that higher earnings level and if you put your money in an RRSP at age 25 only to find out that you need to get it out at 30 or 40 to deal with a crisis just as your income is rising, then you might be taking the funds out at the exact wrong time. The TFSA gives you the flexibility that you can’t get from an RRSP which is why I now see the TFSA as the primary savings vehicle that Canadians should consider first.
Of course, there are exceptions, like the high earner in prime savings mode with a mortgage that is already paid off. There are other exceptions and in no way do I think you should take this commentary as investment advice appropriate to your situation. As always, everyone should have someone they can go to that understands taxes and investments to help them with these decisions. All I am trying to give you today is a new way of thinking about your options.
The one piece of advice I am comfortable giving is that it is hard to have too little debt or too much savings. Get to work!