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RRSP or debt?

Dale Jackson
financial planning

Expect to be swamped with RRSP adds over the next few weeks.

The finance industry generates a good chunk of its annual revenue this time of year by guilting us into thinking about our futures.

Someone should. According to Statistics Canada only 26 per cent of eligible Canadians contribute to their registered retirement savings plans.

One thing you won’t hear a lot about from the finance industry this RRSP season is ballooning household debt levels. At a time when the average Canadian household owes $1.64 for every dollar of income, many banks boost their bottom lines by offering RRSP loans.

Borrowing to contribute to an RRSP only make sense if the amount is less than the rebate, and you have the discipline to actually use the rebate to kill the debt. If you have existing debt here are a few things to keep in mind this RRSP season:

An RRSP is a temporary tax break

Any RRSP contribution made before the March 1st deadline can be deducted from your 2012 income. That means if you contribute $5,000 against income in a 26 per cent tax bracket, your tax bill will be reduced by $1,300.

That $5,000 will be sheltered from taxation until it is withdrawn from the plan – presumably when you are in a lower tax bracket in retirement. Until that time it can be invested in just about anything. If you invest well, those gains will also be sheltered from the Canada Revenue Agency until it is withdrawn.

When it is withdrawn, the $5,000, as well as the gains, will be fully taxed at your present rate.

Of course, there is a risk your investments could go down in value. If that happens the lower amount is taxed.

There is no shelter from debt

That $5,000 will probably go a lot further if it is used to by pay down debt. Think of it as a risk-free, no fee investment that generates a tax-free return equal to the rate of interest being charged, plus any interest compounded over time.

It’s a no-brainer for credit card debt which generates interest payments in the upper teens and can go as high as 30 per cent for credit cards sponsored by major retailers (That’s you Hudson’s Bay Company).

A $5,000 payment against debt at 30 per cent would result in interest savings of $1,500 plus any compound interest it would have accumulated.

Compare that with the $1,300 temporary tax rebate from an RRSP contribution and it’s easy to see that paying down debt makes more sense.

Even at a rate of 10 per cent there’s a big guaranteed return. A $5,000 payment would result in interest savings of $500 plus whatever interest the interest would have generated.

Keep your money at home

That argument even applies to homeowners who are torn between making an RRSP contribution and boosting mortgage payments.

Carrying debt into retirement should not be an option. If your amortization period exceeds the date you are hoping to retire you need to increase regular payments to be debt free at retirement. A mortgage calculator can come in handy to determine exactly how much.

Each dollar spent toward paying down a mortgage not only results in a tax-free return equal to the interest rate, but it also becomes a dollar of equity in your home. Assuming your home appreciates in value that equity is also allowed to appreciate tax free if it is your principal residence.

Increasing mortgage payments makes even more sense for young homeowners with big mortgages because they can carry their allowable RRSP contributions forward to years when they are in a higher income tax bracket, and the savings are greater.