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moneysense.ca, 7/02/07
RRSP Tip # 1: Should you Contribute?
Current issue:
As the deadline for contributions to your RRSP approaches (March 1, 2007 is the deadline for 2006 contributions), you are going to be bombarded with full-page newspaper ads, commercials in television and radio and even phone calls at home (I’ve received three calls already). Instead of being hustled into doing something, take a deep breath and find out if making a contribution even makes sense for your financial situation. While RRSP’s are mostly a good thing because they allow you to contribute pre-tax dollars and you get to defer taxes on interest income, dividends or capital gains you receive within it, they may not be suitable for everyone.
A significant percentage of Canadians earn less than $30,000 per year and if you earned a low income [Update: should read "taxable income of less than $36,378". Thanks to Rob Smith, author of Dollars From Change for the correction] in 2006 (you were on parental leave or you were unemployed for most of the year), it may be better to invest in a taxable portfolio instead of inside a RRSP. Also, if you have consumer debt like a credit card debt or unsecured loan, it is usually better to pay down the debt first.
You should also note that some financial planners argue that it is better to pay down all forms of debt, including mortgage debt, before contributing to a RRSP. If you are more comfortable making a pre-payment on your mortgage then you may want to tune out the messages and skip the RRSP contributions.
NB: If you haven’t done so already, you have less than twenty-four hours to enter in the Spend Smarter, Save Bigger book giveaway. Details are available at the end of yesterday’s post.
moneysense.ca, 7/02/07
[...] The Canadian Capitalist had a link to article by the Smoke & Mirrors guy, David Trahair, called “Don’t Invest in an RRSP Before Paying Down Your Mortgage.” He starts off by saying that the conventional wisdom of investing in an RRSP then applying the tax rebate to your mortgage every year is hard to do. Instead, he says, don’t contribute to an RRSP, but put down more principal on your mortgage. If you want to talk psychology about what is “harder to do” I would suggest that contributing your maximum room to an RRSP is a better forced savings plan than applying an extra lump sum on the principal of your mortgage ever year, but that’s just me. Or maybe he’s suggesting you re-amortize for a much shorter period (after forgetting about RRSPs) but he doesn’t say that explicity. His second argument is that banks just want your money for RRSPs so they can charge you “commissions and fees on your contributions” (doesn’t make sense) and because the banks’ ideal is for you to be in constant debt. I don’t buy any of that as a reason to pay down a mortgage instead of an RRSP. What I care about is which one is better for me (regardless of whether the bank benefits). Just like I don’t care about MERs in principle. What I care about is the returns after costs. [...]
My post yesterday may be helpful to some of your readers.
http://www.milliondollarjourney.com/who-should-contribute-to-an-rrsp.htm
Cheers,
FT
My two cents is as follows:
I would adjust the $30K figure cited in the post to read “taxable income of less than $36,378″. Above this taxable income level, your marginal tax rate jumps considerably making RSP deductions far more lucrative.
I would also add that you can CONTRIBUTE to the RSPs, just do not DEDUCT the amount on your return. The money is still sheltered and working for you, but you hold off the deduction until your income is higher. (FYI – find your Taxable Income on Line 260 of your return, and the $36,378 figure in the boxes at the top of on Schedule 1 of your return).
Make no mistake about it: Maximizing the tax rate of deductible contributions and minimizing the tax rate on eventual withdrawals is by far the most missed opportunity made by RSP investors. This aspect is also ignored in almost every ‘RSP vs. Mortgage’ article you will read. Learn this aspect and you’ll be well rewarded for doing so.
Lastly, paying down credit card debt is definitely a winning financial move; however, the balanced must not be run back up. This would seem obvious, but merits a comment. Too many people pay of credit card debt, suddenly feel “rich” again with their new purchasing power, and – inevitably – up go the balances again. Similarly, people strive to pay off their mortgage, and then suddenly upsize their home, incurring more debt. In both of these examples, the money has not been saved, rather it has been SPENT – indirectly maybe, but it has been spent. In these cases, RSPs would have been the better route. Again, this fact is missing from most ‘RSP vs. Mortgage’ articles. Debt pay down can be temporary, or what I call “true mortgage pay down”. If it is the latter, great, if it is the former, you may be deluding yourself poor.
While most suggest that it is best to contribute to the RSP and then use the tax savings to pay the mortgage – I feel this advice is too often there to simply overcome any objections and simply convince you purchase an RSP. A better approach (especially at low interest rates like we currently enjoy) is to look at the equity in your home if you sold, and compare this to your RSP balance. Keeping these two figures roughly equal is a good simple strategy, so allocate your dollars to whichever has the lower value.
Maybe that was four cents.
Interesting comment Rob (and others). I’d like to add one thing to the debate: Another thing to consider about the rsp vs mortgage debate is risk. If a young couple for example has a large mortgage and a small rsp I would say they face a lot more risk from the mortgage than from the lack of an rsp. Interest rates could go up, one person could lose a job, babies start appearing etc. I would suggest they should concentrate more on the mortgage until it gets to a less risky level. At that point they can reasses and maybe start or increase their rsp contributions. What Rob said about the size of the rsp & home equity is veryinteresting but it doesn’t address the size of the debt. I think a formula to determine how much you should pay down the mortgage each year and contribute to rsp (note I said “and” not “or”) would involve the current rsp amount and the persons age, the mortgage amount and monthly payments as a percentage of their net income, risk tolerance should probably be in there as well. As to what that formula is? I’ll leave that for one of you brainiacs to work on!
Well said.
Saving — whether for retirement or just in general — is always a good thing, but it’s important to remember this time of year that RRSPs are only one option. Used correctly, they can be a valuable savings tool. But don’t get blindly swept up into the hype.
Rob: Thanks for your comments.
I think you are totally right in this statement: “Maximizing the tax rate of deductible contributions and minimizing the tax rate on eventual withdrawals”. I am planning a future post on the anti-RRSP brigade and discuss this point. It all depends on what assumptions are made and assuming that a RRSP is melted down in a single year and the highest tax paid on withdrawals is an unrealistic assumption.
Totally agree GIV. The right tool for the right job!
One more long-winded comment I want to make about rrsps (I really need a blog of my own so I don’t have to keep hijacking CCs blog). I don’t get the obsession with trying to contribute exactly the maximum. Three years ago when I was doing my 2003 taxes my rrsp limit was $13,500 – apparently if I contributed that much then everything would be fine. 4 years later the limit is up to $18k which is an increase of 10% per year. Meanwhile my total salary hasn’t gone up more than maybe 2% per year, my lifestyle hasn’t changed, my retirement goals haven’t changed – so why all of a sudden to I need to contribute so much more? Was I not contributing enough back in 2003? What happens if my limit keeps increasing by leaps and bounds? I might end up in the poorhouse trying to keep my rrsp topped up.
I think the govt of Can. should put out public service announcements during rrsp season to the effect of “Rsp limits are set by the government based on how much tax the government is willing to defer each year. It has nothing whatsoever to do with your personal financial situation. Please do due diligence on your own financial situation to determine an appropriate amount of money to contribute to your rrsp each year.”
Mike: I don’t remember the exact details but the RRSP limit was static and not indexed to inflation for a number of years, so there is a bit of a catch-up in the limit hikes.
I also think that the government probably figured that a large number of boomers are going to retire, so they can now hike the limits and in the future say: “Did you notice how we kept increasing the limits. Its your fault that you don’t have much money saved”. As you can tell, I am cynical about politicians.
Mike, as you mentioned on my blog, it is an alternative for a young couple to pay down their mortgage. But you also have to realize that paying down your mortgage also results in the young couple losing out on valuable compound interest time. As mentioned before, perhaps a solution that would fit most situations is put money into the RRSP (as much as possible), take the tax return, and plop it onto the mortgage debt.
FT
http://www.milliondollarjourney.com
True, true.
FT – I agree that compounding is a powerful force but doesn’t it work exactly the same way on debt as well as assets? For example if I lent you $1000 for 20 years at 7% compounded annually and you invested that money and got an annual return of 7% (lets pretend there are no fee or taxes involved) how much money would you have left over after you paid off the debt?
I’ll accept that you are probably making the assumption that investment returns will be higher than mortgage rates which I’ll go along with but whenever you make assumptions, you add uncertainty to the equation so you can never be 100% sure.
FT: I’ll second Mike’s point. Interest savings on the pre-payment on the mortgage also compound but the key difference are your savings are guaranteed and after-tax.
I’ll give a personal illustration. If you were choosing between mortgage paydown and RRSP in 2000, in hind sight, which option would have been better? The answer would be different if you had the same dilemma in 2003. But we know that only now. So, your guess is as good as mine and there is no right/wrong answer.
CC you got me thinking of certainties and probabilities. In my case I’m basing my retirement planning on retiring in 22 years. In that 22 year time frame I’m assuming that my portfolio (80/20 eq/bond) will get 7% for most of that time and then decrease down to 5.5% by the end of the 22 years. Probably an average of 6.5%. Realistically I’m expecting an average return of at least 5% otherwise I’ll have to either contribute more or work longer – but what is the probability that that will happen? I know there are long periods in the last century where this portfolio wouldn’t have gotten 5%. It would be interesting to find some historical data and look at all the 20 year segments and figure out the compounded return for each of those segments – this might provide some clues as to the odds of my portfolio achieving over a certain rate.
Mike: I think you’ll need to run a Monte Carlo simulation (does anyone know about a free one?) but I’d venture a guess that a 6.5% average return is a reasonable assumption. You are going to be investing periodically, over the years in bull and bear markets. The long periods you are referring to is assuming you don’t invest new money or reinvest dividends.
You can try this calculator from the Stingy Investor website, but it only goes back to 1970.
Link
CC,
On the topic of RRSP contribution room – I have a large amount of contribution room, wondering if it’s best to let it build up to when I am making more money and then catch up with a $50,000k contribution or is it better to contribute little by little every year.
Relating to Mike’s point #4 – Mike’s points make sense, however I have a different take on risk to offer.
mike says – “I’d like to add one thing to the debate: Another thing to consider about the rsp vs mortgage debate is risk. If a young couple for example has a large mortgage and a small rsp I would say they face a lot more risk from the mortgage than from the lack of an rsp. Interest rates could go up, one person could lose a job, babies start appearing etc. I would suggest they should concentrate more on the mortgage until it gets to a less risky level. At that point they can reasses and maybe start or increase their rsp contributions. ”
*****
I say…
‘higher mortgage PLUS higher RSP’ = less risky
‘lower mortgage PLUS lower RSP’ = more risky
To have a $200K mortgage and a $100K in RSPs (net worth = negative $100K) is far safer, than owing the bank $100K (same negative $100K net worth) and having little else to fall back on.
I feel too many people underestimate the importance of having options and control when things go badly. RSPs give you options and control in that should you get into financial trouble due to job loss, sickness, etc, you can always withdraw from RSPs to cover the mortgage payments until you get back on your feet. If you don’t have RSPs to fall back on, you may not be able to make your payments. The bank can get cruel when they feel their money is at risk – that is not what you need when you’re down.
Again, I feel Mike’s points about risk are sound, however just wanted to add that perspective.
Rob that’s an excellent point about having the rrsp to fall back on which I hadn’t really considered. That actually make me feel better about my own situation! (I have a half decent rsp and an uncomfortable mortgage)
I think my point about the young people is that they have lots of time to save for retirement so the lack of rsp is not really risky in terms of will they have enough when they retire. But they could certainly use an rrsp as a backup income plan as well.
Loki: 2 things – 1 – I think Rob? might have pointed out that you can contribute now and then use the contribution for tax purposes later on when you feel it’s more appropriate. 2 – if you contribute too much in one year then you can reduce your marginal tax rate and won’t get as much benefit. It’s best to research the various tax brackets and make sure that you stay in a high one when you make contributions. I think it’s better to spread out the ‘catch-up’ contributions rather than do it all in one year.
I don’t know why people try so very hard not to understand why the RRSP is a trap that mainly serves banks and others in the financial sector.
Most people have a mortgage they are carrying and in servicing that debt they will pay a small fortune before finally owning their home.
Meanwhile they are being encouraged to put money into an RRSP – and even to borrow to do so – where nobody but their financial institution will make use of it until they are forced to withdraw it at which time it will be 100% taxable.
Yes, they will likely be withdrawing it at a time when their income is lower than when they were making the contributions, but it is not “free” when it comes out because they will still be in a tax bracket and they will still pay tax.
Mortgage is a lousy form of debt because unlike in the US it doesn’t provide for any tax advantages on a principal residence.
Contrast that with debt incurred in borrowing for investment purposes – fully tax deductible.
So it is really a no-brainer – you should be putting every dime you can find towards your mortgage and borrowing back the equity for investing outside of an RRSP where the interest will be tax deductible.
The mortgage will be paid off rapidly and you will have a huge investment portfolio and the interest on the borrowed money to acquire it is fully tax deductible. You keep that loan and continue deducting the interest even after you have paid off your mortgage.
Then you start taking that same amount of money you were putting towards your mortgage into your non-RRSP investment portfolio and focus on dividend and other tax-friendly income generation and the proceeds from that are yours – 100% to do as you wish.
So many people have spent so much time trying to sound like the wealthy barber that they haven’t seen the forest for the trees. RRSPs are for suckers. The bank loves them. The bank loves mortgages even more.
What the bank loves is not what is good for you. Think about it.
[...] Let’s say that you have decided that making a RRSP contribution makes sense for you. You are ready to contribute but you are not sure how you should invest your money. What do you do? It is very important that you don’t buy some mutual fund just because you want to beat the deadline. [...]
I’m confused about the whole RRSP and RSP thing.
Could someone please explain to me what they are?
What are the differences between them?
Do different parties sell them?
Does owning an RRSP instead of an RSP, or vice-versa, have more advantages?