At Catalyst, we have an entire division dedicated to your wealth planning needs. It’s a new year and finances are on most people’s mind again. The Registered Retirement Savings Plan (RRSP) contribution deadline is March 1st, and $6000 of new contribution room has been added to Tax Free Saving Accounts (TFSA). Before investing, it is good to get a refresher on what considerations should be taken into account when using each saving vehicle. It will help to better understand what is best for a specific situation and financial goals.
We asked our own internal financial planning expert Simon Wong for some investment advice when it comes to Registered Retirement Savings Plans (RRSPs), Tax Free Savings Accounts (TFSAs) and Mortgages. Here what he had to say:
“Most people understand that it is essential to save for the future. However, with the myriad of choices, it is often confusing where to start. The most frequently asked question as a financial planner I get asked is should I invest in RRSPs, TFSAs or pay down my mortgage (I would consider paying down your mortgage as a form of saving.)
The primary goal of putting money into your RRSPs or TFSAs is to increase your net worth. Paying off your mortgage accomplishes the same objective by decreasing your liabilities—the confusion of what choice to pick arises because each saving vehicle has its advantages and disadvantages. Let’s take a look at these before discussing which option is the best.
Registered Retirement Savings Plan (RRSP)
1. Contributions are tax-deductible, which means a potential tax refund. It is possible to redeploy this tax refund into additional savings such as RRSP, TFSA or even pay down debt. The higher your current marginal tax rate, the more savings in taxes you will have.
2. There are no taxes on investment earnings as long as they stay in the RRSP, meaning tax-free compounding leading to faster growth of money.
3. There is potential for income splitting in retirement with spousal RRSPs.
4. Can be withdrawn tax-free with First Time Home Buyers Plan to purchase your first home.
5. Can be withdrawn tax-free with Lifelong Learning to fund education as an adult
6. Protected from creditors
1. Withdrawals are considered ordinary income and are subject to a withholding tax.
2. Withdrawals can potentially impact income-tested benefits, such as Old Age Security(OAS) and Guaranteed Income Supplement(GIS).
3. Contribution room is limited based on the earned income you make. If you have a lower earned income or get paid mostly in dividends, this could mean you have minimal contribution room to invest in RRSP.
4. If you withdraw from an RRSP, that contribution room is gone, unlike a TFSA, which you will get back the following year. With the loss of contribution room and withdraws being taxable, RRSPs are very inflexible.
5. Mandatory withdrawal age at the end of the year you turn 71. You will have to a forced annual minimum withdraw that will increase each year on a percentage basis.
6. Non-CPP pension contributions will reduce the RRSP room available.
Tax Free Saving Account (TFSA)
1. Similar to an RRSP, the investment earnings inside a TFSA are not taxed. Again, the TFSA will have tax-free compounding like an RRSP.
2. All withdraws from a TFSA are tax-free, unlike an RRSP. You will never have to pay taxes on any investment income earned inside a TFSA.
3. If you make a withdrawal from a TFSA, you will get that contribution room back the next calendar year on Jan 1.
4. New contribution room is the same for everyone regardless of income.
5. No mandatory withdrawal when a specific age is reached like an RRSP
6. Withdraws will not affect government benefits like OAS or GIS.
7. You can share contributions with a spouse since TFSA contributions are made with after-tax money, there is no attribution of earned income back to the contributing spouse.
1. There is no tax deduction for contributions into a TFSA, unlike an RRSP.
2. No Protection from creditors
3. Annual new TFSA contribution room is comparatively much smaller than new RRSP contribution.
4. Investment options are restrictive for TFSA compared to RRSPs
Paying off a Mortgage
1. The interest rates on a mortgage are usually set for years, which means you know precisely the rate of return you get from paying down debt. The rate of return is also guaranteed; unlike an RRSP and TFSA, the market returns are not known.
2. There are many soft benefits of paying down debt, such as reducing emotional stress and not having the uncomfortable feeling of money owed.
3. After paying off a mortgage, there is an increase in discretionary cash flow for other uses such as investing or lifestyle needs.
1. The interest rate on mortgages tends to be lower. The lower interest rate means that you can often get a better rate of return in the long run by investing in the market than by paying down debt.
2. Investing early in life allows an investment to compound for a more extended period and leads to larger nest eggs. Focusing solely on paying down debt often leads people to be house rich with very little for retirement. Having all your money in one asset class(your home) in one geographic location could be very risky for your retirement cash flow.
What’s the best option?
Now that we have looked at the considerations that affect whether investing in RRSPs, TFSAs or paying down a mortgage is the best, let’s chat about best practices.
Generally, it makes sense to invest excess income into an RRSP or TFSA before paying off a mortgage quicker. TFSA and RRSP Investments can grow tax-free, and returns can compound. There is no year-to-year tax impact from investing inside of either the RRSP or TFSA. If you invest in the markets, TFSAs and RRSPs tend to get a better return rate than paying down a mortgage. These reasons make it very attractive to invest inside both a TFSA and RRSP over paying off a mortgage.
However, this is not always the case.
RRSPs can be very disadvantageous at certain income levels and in different situations. If an individual expects to have a very high taxable income in retirement, an extensive RRSP portfolio could lead to an OAS clawback, and they might end up paying more taxes than you save investing in RRSPs. In that case, it makes much more sense to pay off the mortgage early than to maximize their RRSP contributions.
TFSAs can also be very dangerous if an individual is terrible with money. The flexibility in the TFSA and lack of consequences of withdraws can make it very easy to spend investment earnings. It may be difficult for some people to keep the money inside the TFSA and save for the long term. In that case, paying down a mortgage is a better choice as it is not as easy to take out equity from a home.
These are only a couple of examples of when it is more beneficial to pay off a mortgage vs investing in a TFSA or RRSP. Deciding which choice is best for you is not just about taxes and rates of return. Each person’s situation is going to be different. When making a large financial decision, it is essential to look at the whole financial picture and not just one aspect. Choosing between investing in a TFSA, RRSP or paying down your mortgage may seem like a simple decision, but there’s a lot to consider.
The sooner you take action to make the right decision for yourself, the larger the impact on your financial future. It is essential to get a customized financial plan and talk to a professional financial planner to determine the best path when deciding whether to invest in RRSPs, TFSAs or paying down your mortgage.
Simon Wong MBA, CFP, CLU, FCSI. CIM, PFP, FMA, B.Comm
If you have questions or would like to get a customized financial plan. Simon can be contacted at (403) 968-1125 or firstname.lastname@example.org