One of the most common questions asked by Canadian taxpayers is whether they should use their excess disposable income to invest in RRSPs or pay down their mortgage. Since contributions to an RRSP are made on a tax free basis, reduction in taxes payable can be substantial. Conversely, higher mortgage payments can result in significantly lower interest expense. As such, there several factors to consider when deciding which option is better:
Tax Bracket: The benefits of investing in RRSPs are greater with individuals in higher tax brackets. A $10,000 contribution will result in a reduction of $4,000 in taxes payable for someone with a marginal tax rate of 40% compared with $2,000 for someone with a tax rate of 20%. Keep in mind that a refund is only available to the extent of your remaining contribution room.
Rate of Return on RRSP: One of the benefits of any investment are the effects of compounding i.e investment returns are reinvested at the same rate. Additionally, all returns on your investment portfolio accumulate tax free further increasing your rate of return. For example, an investment of $10,000 earning a return of 5% (with NO further reinvestment) will be worth $33,000 at the end of 30 years.
Mortgage Interest Rate: Reductions in principal balance result in lower future interest expense. The higher the interest rate, the greater the savings, so it makes sense to pay off mortgages with higher interest rates sooner. As an aside, a weekly repayment schedule, will result in lower interest expense over the life of the mortgage.
Mortgage Early Repayment Penalty: Some mortgages carry a penalty for early repayment. This needs to be evaluated before any early repayments are made .
Age of Taxpayer: The effects of compounding are greater with a longer time horizon. Consequently, a younger person would benefit more from the compounding effects of investment returns compared to someone who is approaching retirement age. Additionally, it is better to retire debt free so as to reduce post retirement cash outlays.
Diversification: One of the most important tenets of investing is to ensure that you have a diversified portfolio. Reduction of debt results in future savings which should be balanced with investments that earn returns. Also, in light of the recent economic meltdown where equity portfolios were decimated, it is even more important to diversify.
A tax planning technique used by many is to contribute the maximum to your RRSPs (if possible) and use the resulting tax refund to pay down your mortgage. This allows you to take full advantage of the available tax reduction while also reducing debt and diversifying. This seems prudent especially in the current economic environment, where interest rates are low and the need for diversification has proven to be imperative.
You might also be interested in: