If you’ve got a case of the January credit card blues, you should first use your cash flow to repay high-interest debt. As high-interest debt melts away, you’ll have more money to contribute to your RRSP and TFSA. Your marginal tax rates now and in retirement will determine which of these two is best.
Ideally, Canadians would pay off their debts and remain debt free. They would contribute the most that they can to their RRSPs (Registered Retirement Savings Plans). They would also contribute as much as they can to their TFSAs (Tax-Free Savings Accounts). The trouble is, many Canadians are in debt and lack the cash to improve their financial health. In such cases, Canadians need to plan on how to allocate their cash among these competing options.
We believe that most Canadians would be best off by paying down high-interest debt. Many Canadians fail to pay off their credit card debt in full each month. As a result, they pay almost usurious rates of interest on this debt. Some consumers are also paying horrendous amounts of interest on loans to buy cars—loans sometimes peddled by car salespeople.
Repaying high-interest debt gives you large pre-determined savings. Every dollar you put towards your credit card debt can save you as much as 20 cents in interest. It’s likely that RRSP or TFSA contributions will generate returns far below 20 per cent.
Tax refunds are a great way to repay debt
There is one case where contributing to an RRSP can make sense. That’s when you pay a high marginal tax rate. In this case, large RRSP contributions generate large tax refunds. You can then apply this cash against your debt.
When you repay debt, you should start by focusing on the highest-cost debt, of course. Then work your way down. Ultimately, you’ll have only low-interest debt left, such as a mortgage. In this case you can let your regular mortgage payments service the debt. There’s no need to accelerate the repayment of debt on which you pay little.
Canadians owe, on average, about $1.78 for every dollar of income. This means that it will take some Canadians a long time to dig themselves out of debt. The problem with this is that compound interest has less time to work its magic in their RRSPs and TFSAs. On the positive side, you no longer lose contribution room to your RRSP and you can carry TFSA contributions forward over time. Once you’re out of high-interest debt, it’s important to resist human nature and remain debt free.
As your debt and interest payments fall, your cash flow should rise. This will give you the means to invest. The question is, what’s better: a RRSP or a TFSA? The answer depends upon your marginal tax rate today and in retirement. If you expect to pay a higher marginal tax rate in retirement than in your working years, then you should focus on a TFSA. If you expect to pay a lower marginal tax rate in retirement, then concentrate on an RRSP.
Can you resist the TFSA ‘cookie jar’?
TFSAs suffer from one disadvantage: they’re too much like a ‘cookie jar’. That is, it’s so easy to withdraw the money. So some people will find it hard to save up much in their TFSAs.
RRSPs are different. If you take out cash, it gets added to your income for tax purposes. The income tax payments are effectively a penalty on RRSP withdrawals. As a result, people are less likely to yank money out of these plans. That means that it’s easier to accumulate significant wealth inside a RRSP. And since the money is more long term in nature, investors can invest it in more profitable long-term investments. Investors can put their RRSP dollars into stocks. This will usually generate more than interest on a TFSA that serves as an emergency fund.
This is an edited version of an article that was originally published for subscribers in the January 11, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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