Personal Investor: Pay down debt or contribute to RRSP?
If you’re torn between contributing to your registered retirement savings plan before the March first deadline or paying down debt – it might be time to step back and choose a side.
Paying down debt isn’t as interesting as investing and getting a tax refund, but in most cases it’s the best investment in your future. You won’t hear that from the finance industry as it simultaneously pitches for your investment dollars, while earning interest on your debt.
Whether it’s better to pay down debt or make an RRSP contribution depends on two things: the interest rate on your debt and the tax savings from an RRSP contribution.
First, here are some typical interest rates on debt. Note how high they are for balances on credit cards and ask yourself if there is any way to get an equal return on any investment without tax consequences or risk. The answer is no for all but the lowest rates – and even the safest investment – will have a hard time returning 2.5 per cent.
Credit card balances: 18% to 29%
Consumer or student loan: 10%
Secured line of credit: 3.75%
5-year fixed mortgage: 2.5%
But there is more to RRSPs besides the ability to grow your investments. Contributions can be deducted from your taxable income. The size of that deduction depends on your tax bracket. The chart below rounds off tax rates on income for residents of Ontario, but they don’t differ much across the country.
Under $40,000: 20%
$45,000 to $90,000: 30%
$90,000 to $140,400: 37%
$140,400 to $200,000: 41%
$200,000 and up: 46%
So, your tax break is roughly equal to your marginal tax rate. If you are in the lowest tax bracket, your tax savings are minimal. In that case, paying down your mortgage is probably a better investment option, but there is another benefit. RRSP contributions and gains are fully taxed when they are withdrawn. Investing in your principal residence has a tax advantage just like a tax free savings account (TFSA) in that you are never taxed on the amount it appreciates in value when it is sold.
If you choose debt over an RRSP contribution, your contribution space can also be carried forward to future years when your debt is lower, you are in a higher tax bracket, and the tax savings are bigger.