RRSP, TFSA or mortgage?

Clients who contribute to RRSPs are often eager for the immediate gratification of a tax refund.

But counsel them to avoid this knee-jerk reaction, says Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management.

In some cases, they may be better off contributing to TFSAs or paying off mortgages, finds a CIBC report.

“If someone has non-deductible, high-interest-rate debt—like credit card debt—then paying that down first is the best financial decision. [They should delay] contributing to an RRSP or TFSA,” Golombek says.

Read: 5 common RRSP pitfalls

For clients with no consumer debt but limited funds, the traditional toss-up has been between TFSAs and RRSPs. However, mortgage debt is another place they can allocate cash.

That may appear imprudent since current mortgage rates can be 3% or 4%—lower than classic expected rates of return.

“[Clients] may assume they’ll get a higher return on their RRSP or TFSA,” says Golombek. “The problem with that view is it ignores the risk with equity investing.”

Read: 5 ways to decide between TFSAs and RRSPs

He adds, “When you have a five-year rate on your mortgage, it’s guaranteed. But it’s impossible to guarantee a five-year rate on a [risky] investment” that may return more than mortgage interest rates.

Instead, “compare apples to apples from a risk perspective. Look at the Government of Canada five-year bond yield. The yield this week is just under 1.5%. If your client’s mortgage interest rate is higher, it may make sense [for him] to pay down the mortgage.”

Tax considerations

Mortgage interest isn’t deductible, so another factor in choosing where to allocate funds is tax advantages.

For RRSPs, “If your tax rate drops from the year of contribution to the year of withdrawal, there’s a tax-rate advantage. That can boost the advantage of having an RRSP contribution over debt,” says Golombek.

Read: 15 tax credits to help clients save

His report suggests clients follow the following rules when the rate of return on investments in an RRSP equals the interest rate on debt:

• If your client’s tax rate is expected to be lower in the year of RRSP withdrawal than it is today, an RRSP contribution yields a higher benefit than debt repayment. That advantage grows the longer the funds remain in the RRSP.
• If your client’s tax rate is expected to remain the same in the year of RRSP withdrawal as today, an RRSP contribution and debt repayment yield the same benefit.
• If your client’s tax rate is expected to be higher in the year of RRSP withdrawal than today, debt repayment yields a higher benefit than an RRSP contribution. The debt advantage increases with time.

However, when a client’s current tax rate is the same as her expected tax rate at the time of fund withdrawal—and when the investment rate of return is the same as the rate of interest on debt—it makes no difference whether they choose to invest in an RRSP or TFSA, or pay down debt.

Read: RRSPs are more than tax tools

And regardless of what clients choose to do, they’re “going to be ahead of the game because they’re saving for their futures,” says Golombek.

He adds, “They can maximize the benefits by looking at how rates of returns, tax rates and time horizons impact those savings, but setting something aside for the future is always a good thing.”

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.