February is RRSP season, and there is no shortage of advice available to Canadians on tax-free investing before the deadline of March 2.
One question which often arises at this time of year is whether homeowners should place available cash in an RRSP — or borrow the RRSP contribution — or use the money to pay down their mortgage.
My advice has always been that anyone who has a principal residence should not invest in an RRSP as long as there is a mortgage on the home.
Much of the advice available online and through financial institutions recommends investing as much as possible into the RRSP and using the tax refund to pay down the mortgage. But when advice comes from a source which is promoting RRSP investments, can it truly be unbiased?
In deciding which way to go, some of the factors include:
- Interest rate: If the mortgage interest rate is higher than the return earned inside the RRSP, some advisers say it is better to pay down the mortgage.
If the return inside the RRSP is higher, other factors come into play. There may be a preference for paying down the mortgage if the interest rate is at least two percentage points higher than the investment returns in an RRSP.
- Your age: The closer you get to retirement, the more important it becomes to have sufficient assets inside an RRSP to fund retirement. But building equity in a home is equally important to many homeowners.
If, for instance, a 25-year-old has no RRSP until her mortgage is paid off, then 15 years later at age 40 she can still make considerable RRSP contributions over the following 25 years before retirement. That’s still lots of time to play catch-up.
- Investment discipline: Once the mortgage is finally paid off, the amount of the former monthly payments should be regularly used to “catch up” on the RRSP. Will you have the discipline to do that? Or will the car dealer’s showroom or travel agent’s office beckon you?
- Tax on withdrawal: All proceeds of an RRSP, or its conversion into a Registered Retirement Income Fund (RRIF), are taxable on withdrawal. This could put the taxpayer into a higher tax bracket on retirement.
- Liquidity worries in future: An RRSP provides a ready source of funds in an emergency. But having a large equity in a home allows a homeowner to obtain an equity line of credit. The equity built up in the house is its own nest egg.
- Retirement pension plan: A generous workplace pension plan that will provide a secure retirement offers the opportunity to concentrate on the mortgage more than the RRSP. Those with no pension plan are usually better off paying down the mortgage.
- Inheritance: By the time many young people today reach retirement, they will have inherited the wealth of their parents or grandparents. If retirement looks secure for this reason, paying down the mortgage makes more sense while they are in their 20s and 30s.