Tax Matters

Jamie Golombek

As managing director of tax and estate planning with Canadian Imperial Bank of Commerce's wealth advisory services division in Toronto, Jamie Golombek is quoted frequently in the national media as an expert on taxation.

With just hours to go in this year’s RRSP deadline, emphasize retirement savings over debt repayment

By Jamie Golombek |

Monday, March 2 is the last day of RRSP season — the deadline for clients to contribute to their RRSPs and allow them to claim a tax deduction on their 2014 tax returns. For Canadians facing record levels of debt, however, contributing to an RRSP in 2015 may seem like a luxury they simply can't afford.

The decision to pay down debt, at the expense of retirement savings, is often an emotional one that isn't driven by the numbers. With mortgage interest rates at a 60-year low, neglecting long-term savings in favour of debt repayment may result in sacrificing the quality of retirement.

A recent poll from the Canadian Imperial Bank of Commerce (CIBC) asked Canadians whether they would contribute to an RRSP or pay down debt if they had extra funds available. Surprisingly, 72% of respondents favoured debt repayment over retirement savings. The primary reason the majority of those who preferred debt repayment cited was simply the desire of having the financial freedom of being debt-free. This emotional rationale far outweighed other more practical reasons given by the respondents, such as concerns that interest rates may increase in the near future or that their current debt level was too high for comfort.

This confirmed the results of a previous CIBC poll that revealed 85% of Canadians were taking steps to reduce their levels of personal debt, even though only 16% were actually concerned that they had too much debt. The poll also showed that Canadians are trying to pay off their debt in a hurry, with almost 70% planning to be debt-free within five years.

So, why is there a rush to pay off debt? It's probably safe to speculate that market turmoil in recent years has caused investors to seek financial safety — and what's safer than getting out of debt, right? But that's not necessarily the case. When interest rates on debt are low, as they continue to be right now, the short-sighted objective of getting out of debt now may actually impact long-term retirement savings negatively.

When your clients' tax rate today is the same as their expected tax rate upon retirement, the decision to invest in an RRSP, tax free savings account (TFSA) or pay down debt boils down to a simple mathematical question: Can your clients get a higher rate of return on the investments in their portfolios than the interest rate on their debt, given a level of risk at which clients are comfortable? If so, then investing is the better bet; otherwise, paying down debt is the better choice.

For consumer debt such as credit cards and personal loans, the interest rate can be quite high, often approaching 20%. As it may be difficult, if not downright impossible, to get a higher rate of return on investments with a reasonable amount of risk, it almost always makes sense to pay off this kind of debt before making contributions to an RRSP or TFSA.

On the other hand, mortgage interest rates are at their lowest point in more than 60 years. Consequently, for clients with such low interest rate debt, it might make sense to leave their debt outstanding and, instead, contribute to an RRSP or TFSA if they can hope to generate a higher rate of return on investments over the long term.

Of course, investing in the bond or equities markets as your clients might do within an RRSP or TFSA cannot be compared to paying down a mortgage, which is more similar to a risk-free investment such as a Government of Canada bond. For clients with high levels of debt who would not be able to sustain an increase in mortgage interest rates, it might be best to minimize risk and simply focus on debt repayment.

However, if your clients are willing to tolerate some risk in their investment portfolios while saving for longer-term goals — such as retirement that may be 20 or 30 years away — choosing to invest via an RRSP or TFSA may result in more money at the end of the day, albeit with an assumption of greater risk.

For my full analysis of this issue, please see: http://www.jamiegolombek.com/media/Mortgages_or_Margaritas_EN.PDF