RRSP vs. TFSA vs. Paying Down Debt

When Canadians have some money available, a big decision they face is whether to invest it in an RRSP or TFSA or to focus on paying down debt.  Dave Chilton, The Wealthy Barber, asked me how I thought about this choice on his podcast.  Here I give a fuller answer to his question.

This is really two separate questions.  The first is whether to invest savings or pay down debt.  The second is whether to put savings you’ve decided to invest into an RRSP or a TFSA.

It never makes sense to invest ahead of paying down high-interest debt.  We could make a case for starting to invest a little, just to start the habit, but paying down high-interest debt should be the initial priority.  This leaves the question of whether to invest or pay down your mortgage.

Invest or pay down your mortgage

A popular answer to this question is that you expect to make about 7% per year on your investments, but your mortgage is only 4%, so you should always invest.  This is right some of the time, but it misses many important factors.

The supposed 7% return on your investments is just an average.  In a given year, it could be -15% or +35%.  Even the 4% mortgage isn’t set in stone.  Mortgage rates change, and if you run into financial difficulty, you may end up with car loans, lines of credit, and credit card debt all at higher interest rates.

The real answer to the invest versus pay down your mortgage question starts with risk.  Consider an example.  Your income is $100,000, and your mortgage is $600,000.  What should you do?  Your risk is high.  Assuming you have at least a modest emergency fund in place to weather any short-term problems, the bulk of the savings you can spare should go toward paying extra against your mortgage.

If you have a stable job, and your debts aren’t too high relative to your income, you can consider investing the bulk of your savings, and just make regular mortgage payments.

Another factor in this decision is how you plan to invest.  At one extreme, if investing to you means cash or GICs, then you should focus on paying down your mortgage.  At the other extreme, if you know how to DIY invest at ultra low cost in world-wide index stock ETFs, then the gap between your expected returns and your mortgage rate is higher.  This tips the scale toward choosing to invest.

Imagine that we take your income, mortgage balance, job security, and other relevant factors and give you a risk score out of 10.  Then the high-skill investor might prioritize investing when risk is below 7 out of 10, while an investor who buys mutual funds at the bank might prioritize investing when risk is below 4 out of 10.  The challenge with all this is to judge the level of risk.

Yet another factor is your feelings.  Some people, like me when I was young, really hate debt.  Even when it didn’t make sense mathematically, I chose to pay down my mortgage.  This choice may not be optimal, but it’s not too far from optimal.  You won’t go too far wrong paying down your mortgage, even though the math says to keep a modest mortgage and invest.

RRSP or TFSA

There is a mathematical approach to this question, but there are other considerations first.  If you would invest RRSP assets in a stock and bond portfolio, but you’d leave your TFSA in cash because you misunderstand the “savings account” part of the TFSA name, then you should invest in an RRSP.  If you are more likely to raid your TFSA for frivolous spending, then your RRSP is better for you in the long run.  If you have already maxed out your limit on one of your account types, you have little choice but to save further money elsewhere.

If you would invest RRSP and TFSA assets the same way, you would leave both alone to grow for the long term, and you don’t have enough money to fund both, then we can get to the math of which is better.

The main consideration is whether the tax rate you save on RRSP contributions is higher or lower than the tax rate you pay later on RRSP/RRIF withdrawals.  The answer isn’t just to compare tax brackets now and later.  There are some subtleties.

One subtlety is that you have to take into account income-tested benefits, such as the child benefit and the GIS.  If making an RRSP contribution gets you more benefits, or withdrawing from an RRSP/RRIF reduces your benefits, your effective tax rate is higher than just the tax portion.

When you make RRSP contributions, your contribution amount tends to be a modest fraction of your income.  So, the effective tax rate you save is usually close to your effective marginal tax rate.  If your income reaches into a 30% effective tax bracket, your tax savings are usually about 30%.

When you withdraw from an RRSP/RRIF, there are more possibilities.  Withdrawals from an RRSP/RRIF tend to be larger than RRSP contributions due to investment growth.  Your taxable withdrawals are likely to be fairly large compared to your other income.  You need to look at the average effective tax rate from the level of your other income up to your total income (other income + RRSP/RRIF withdrawals).

Once you have estimates for your effective tax rate on RRSP savings and effective tax rate on withdrawals, you can compare them to decide whether an RRSP or TFSA is better for you.

Because this is fairly complex, experts like to give rules of thumb, such as to use your RRSP when your income is above $60,000 or $70,000.  This isn’t a bad rule, but it can backfire.  Young people with large child benefits may find that the RRSP is better even for lower incomes.  Low income seniors getting the GIS have a very high effective tax rate on RRSP/RRIF withdrawals.  The TFSA is much better if you expect to receive the GIS in retirement.

Here’s an even simpler rule of thumb: it’s better to save than to not save.  So, if you don’t fall into a category where the RRSP/TFSA choice is obvious, just pick one.