When the calendar year draws to a close, many Canadians are deluged with advice, free and otherwise, about what to do with their Registered Retirement Savings Plan (RRSP). January marks a hazy line in contributions, it is the last chance for Registered Education Savings Plan (RESP) contributions and is also considered the time to max out any remaining room on your regular RRSPs, either by setting up financing (taking a loan) or transferring disposable income to your RRSP account (using cash). The soft limit of January is soon followed by the absolute line of March 1, the day your tax year resets as far as your RRSP contributions are concerned. In this article, we'll look at some of the issues surrounding RRSP contributions.
To learn more about RRSPs, check out How are Registered Retirement Saving Plans (RRSPs) taxed?
Paying Off Debt Or Saving For Retirement?
Although most of the popular information on RRSPs makes it sound like you should start one right after the doctor frees you from the womb, now is as good a time as any. The RRSP is often described as the best government created program to assist citizens in preparing for retirement. If you were born after 1970, however, there is a very good chance that it will be the only government program when it comes time for you to retire.
The best way to start an RRSP is by regular contributions. These are automatic withdrawals that you can set for just after payday so that you're never tempted to skip a month.
There is confusion over whether it is worth starting an RRSP while still owing on consumer loans (lines of credit, credit cards, car loans, etc.). From a numbers perspective, it is always more financially sound to pay down the debt first because servicing debt has a guaranteed rate of return in increased disposable income as the debt is reduced, whereas investing of any kind carries risk. (To learn more, read Invest In Spite Of Debt.)
Paying off the Mortgage or Adding to the RRSP?
Mortgages and student loans fall into the gray area of debt when it comes to RRSPs. These debts are usually long term and low interest. Student loans even carry a tax deduction themselves. Again, from the numbers perspective, when you are young, paying down your mortgage should take priority over most investments. Paying down your mortgage faster now will save you a lot in interest payments in the future. As such, your mortgage should take priority thanks to the guaranteed return you earn in interest savings. (To read more, check out Be Mortgage-Free Faster and Paying Off Your Mortgage.)
This is a fact that most people find disagreeable for reasons outside of the numbers. There is a sense of future security that comes from maxing out your RRSP every year, regardless of whether you are making money in it or not. This desire to balance mortgage responsibility with the psychological edge of investing for retirement has led to many different tax strategies. One of the most popular is the system of maxing out your retirement savings plan and using your tax refund to make an extra payment on your mortgage. It keeps you in debt for longer than if you simply used the money against your mortgage instead of the RRSP limit, but it balances financial and psychological necessities.
There is nothing wrong with investing for retirement while paying your mortgage. Doing so is much better than piling up consumer debt while paying your mortgage. If you do decide to go all out on your mortgage, you will still have to switch later and go all out on your RRSP once your mortgage is paid off. You can't cheat and make debt management count for retirement planning or vice versa, but the two are interlinked. In the end, this decision probably comes down to a personal choice.
Adding Debt to Increase Your RRSP
Should you borrow money to max out your RRSP? Generally, no. But if you are like the vast majority of North Americans, you've borrowed to buy a car, furniture, a TV, or to do something else much more financially unwise than to max out your annual contribution. If your RRSP is your only investment vehicle, then you are better off borrowing to max it out and paying cash for something, a car, TV, etc., that you intended to use borrowed funds to buy.
RRSP loans are lower interest, but not tax deductible. If you have investments outside your RRSP, it might be better to max out your RRSP with available funds and then borrow for your other investment accounts. Borrowing to invest in non-RRSP accounts will result in another tax deduction for the interest on the loan you used to invest. This is an excellent strategy, but the end returns depend on your competency as an investor, regardless of whether the loan is tax-deductible. Basically, the goal is to minimize all debt, particularly high-interest, non-deductible debt.
Should you borrow to start your RRSP? That depends as much on personality as your age. If you are in your 20s or 30s, occupy a high tax bracket, and are a poor saver but a diligent debtor, then it may be beneficial in the long run. It may be the most painless way to increase your financial security. The deductions and the long-term compounding you'll hopefully enjoy on your money will generally outweigh the burden of interest payments in this case. Banks cater to this strategy with very reasonable loan terms when the funds are going to be used in an RRSP. If you don't fit the aforementioned category, it is better to go the slow and steady route of regular, automatic transfers.
Remember that the bank advisor who may be pushing for you to borrow is securing a safe return for his or her institution, not you. An RRSP contribution loan is the sweetest type of loan for a bank because it usually offers good short-term returns with a lower risk of default than the majority of loans. At the same time, the numbers-only perspective is very limiting to personal finance as a whole. Perhaps there is someone living a life of perfect financial rationality, but it's doubtful. The truth is that as this year winds down, the only RRSP expert you can depend on is yourself. You know whether adding more debt to get a larger tax break is going to fit in to your financial plan better than anyone else.
To learn more about RRSPs, see our tutorial on Registered Retirement Savings Plans (RRSP).