Check out the following scenarios to see which is most applicable to you.
Scenario 1: Just starting out in your career?
Contributing to an RRSP may not be right for you.
Jennifer is a recent university graduate who owes $20,000 in student loans. She has a job and no credit card debt. She anticipates receiving a $2,000 income tax refund. Should Jennifer use the refund to pay down her student loans, or should she deposit it in a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA)?
“A number of variables will affect Jennifer’s decision,” says Kevin Porter, a CPA, CA in Brampton. “If her income – and, therefore, her tax rate – is relatively low, an RRSP contribution will not trigger a significant refund.”
Roberto Umana, an Associate with Gallagher and Mannisto in Toronto, agrees.
“If Jennifer is making $40,000 a year or less, an RRSP contribution is of little benefit to her,” he explains.
“In five or six years, if her income has gone up to $75,000 or $80,000, an RRSP contribution will really help her because it will trigger a larger refund.”
The upside to Jennifer contributing the $2,000 to her RRSP is that the amount will grow inside the RRSP, tax-free. “It’s important to keep in mind that, even if Jennifer does put money into her RRSP this year, she does not have to claim the deduction this year,” says Porter. “She can carry forward the deduction indefinitely, and use it in a year when her income is higher.”
If Jennifer chooses to forego an RRSP contribution this year, she can also carry forward her unused contribution room.
When she is earning a higher income, she can use that room to make a sizeable contribution to her RRSP, triggering a larger tax refund.
So, if Jennifer does not contribute the $2,000 to an RRSP, should she pay down her student loan or put it in TFSA?
“That depends on the interest rate on her student loan,” says Umana.
“If the interest rate is eight or nine per cent, she should definitely pay down the loan. However, if the interest rate is low, she should pay the minimum required to service the student loan debt and put the $2,000 in a TFSA or RRSP.”
Jennifer may also be able to claim a nonrefundable tax credit for interest paid on her student loan.
Porter agrees that the decision depends on the rate of return.
“Jennifer needs to evaluate her investment knowledge and determine what rate of return she is likely to get in either a TFSA or an RRSP, compared to the interest rate on her student loan,” he says. “Whichever is the best return is where she should invest. It really comes down to doing the math.”
When comparing the returns, she needs to factor in the tax credit she is entitled to.
If Jennifer contributes to a TFSA for several years, she can then withdraw the money and use it to make an RRSP contribution when her income is higher. This option would also increase the TFSA contribution limit she can use in the future.
Scenario 2: Couple should focus on saving for
children’s education and paying down mortgage.
Allan and Eileen are a young couple with a large mortgage, two children and taxable income of $85,000. They have $1,500 available. Should they pay down their mortgage or put the money in a Registered Education Savings Plan (RESP), Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA)?
“The answer largely depends on the timing of Allan’s and Eileen’s financial goals,” says Bill Hyde, a Partner with Millard, Rouse and Rosebrugh LLP in Brantford.
“In this case, funding the children’s education through an RESP is the priority in terms of timing.”
Investing the money in an RESP also provides the highest net economic benefit, Hyde says.
Assuming the couple’s marginal tax rate is 40 per cent, the interest rate on their mortgage is five per cent, and that the marginal tax rate on an RRSP contribution will be the same when the funds are taken out, Hyde calculates that the net economic benefit of a $1,500 contribution to an RESP would be $1,134.
This compares to a net economic benefit of $945 from investing the same amount in an RRSP, a TFSA or paying down the mortgage by that amount.
“The federal government provides a Canada Education Savings Grant (CESG) of at least 20 per cent of the RESP contribution,” Hyde says.
“This additional amount makes the RESP the best option of the four.”
The down side of an RESP contribution is that it does not trigger a tax reduction. Tax is payable by the student on the accrued earnings of the RESP as the funds are drawn out.
However, in most cases, the student is not in a taxable position when this occurs. If the child does not pursue an eligible post-secondary education program, the CESG is returned to the government.
“Contributing to an RESP and paying down the mortgage are a virtual tie in my mind although, the older the children are, the more I would lean more toward the RESP,” says Eugene Cholkan, a Partner with Cholkan + Stepczuk LLP in Toronto. “Otherwise, I would recommend paying down the mortgage.”
Cholkan says financial security should be Allan and Eileen’s top priority. “The last thing they want to do is uproot their young family by selling their home in case of financial difficulty,” he explains. “Several things beyond their control could lead to that, such as job loss or an increase in interest rates.”
For example, an increase of two per cent on a $300,000 mortgage would increase a monthly mortgage payment by about $325, Cholkan says. “Paying down the mortgage principal can help Allan and Eileen keep their monthly payment as low as possible, if interest rates are higher when they have to renew. It also creates equity in their home that can help them get a low-cost home equity line of credit to temporarily cover unexpected expenses.”
Choosing between paying down the mortgage and contributing to an RRSP also depends on the difference between the interest rate paid on the mortgage and the rate earned on the investments inside the RRSP. If the rate earned on investments is higher, Allan and Eileen may want to consider the RRSP contribution, says Hyde. “If the marginal tax rate is lower when the funds are withdrawn from the RRSP than when the funds are contributed, there will be a benefit to contributing to the RRSP,” he adds. “Even if the tax rate is not materially lower at that time, the longer the funds are invested, the greater the benefit of contributing to an RRSP.”
– Chartered Professional Accountants of Ontario
Posted: Feb 3, 2015