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Canadian Investing / Canada - RRSP Strat / Taxation
|Subject: Prepay mortgage or make RRSP contribution?||Date: 2/2/2003 8:11 PM|
|Author: jesting2||Number: 1099 of 1189|
It looks like this board has been pretty much abandoned but just in case anyone out there is interested and would miss it otherwise, I am cross posting this from the Canadian General Board....
At this time of year, we see the question of whether it is better, to contribute to an RRSP or prepay the mortgage. The answer that is often proposed by financial advisors is to contribute to the RRSP and use the tax refund to prepay the mortgage. In his column in the Toronto Star on Feb 1/02, Bob Aaron quips "Nobody earns a fee when a homeowner pays down his or her mortgage." inferring that investment advisors who recommend making RRSP contributions do so primarily to earn their omissions and the banks do not want you to pay off your mortgage faster than necessary.
In response to the advice above, he writes, "For years I have always advised clients - particularly young clients - exactly the opposite: forget the RRSPs and instead pay down the mortgage on their homes as fast as possible"
He goes on to say that the BMO Investment Centre web site states "that excess cash should be used to invest in an RRSP and then the tax refund can be used to pay down the mortgage.
The flaw in this argument is that if it makes sense to use just the tax refund to reduce the mortgage, why not take all of the excess cash, pay the tax on it, forget the RRSP, and use all of what is left over to pay down the mortgage. In this way the mortgage can be paid down much faster."
The way I see this, you are not making the best use of your income by doing this, since you only have the post tax dollars to apply to the mortgage. If you had $5,000 in pre tax dollars and your tax rate was say 30%, you would only have $3,500 to put down on the mortgage. If you put the $5,000 into the RRSP, the full $5,000 would be working for you in the RRSP and the tax refund of $1,500 could be working for you on the mortgage.
Personally, I have never believed that ignoring RRSPs is the correct advice, especially for the younger investor. It has been a long time since I looked at this question for my clients, so I thought I would re-examine it to see if my thoughts had changed. I decided to work up an example based on the following assumptions:
Annual income of $40,000 for someone aged 30 with a retirement target of age 60.
No allowance for increase in income for their working lives.
No pension or DPSP so no pension adjustment to affect their contribution level of 18%.
No allowance for anticipated increases in RRSP contribution limits since the Feds have been pretty chintzy about this in the past.
So here goes:
An income of $40,000 would qualify the investor to put $7,200 a year ($600/mo) into the RRSP. At 5% rate of return compounding annually, would produce a total of $499,355 at age 60.
If we assume a 30% marginal tax rate on their income, their RRSP contribution would produce a tax refund of $2,160 or $180/monthly. Since there is no more room in the RRSP. These funds will have to be invested in a non-registered account, ($180/m x 30yrs x 5% less 30% tax) producing a further $114,374.
In this scenario, the total accumulated by age 60 would be $613,729. Against this would be the interest cost for the mortgage of $111,722 for a net gain of $502,007.
Applying the rebate as a prepayment to the mortgage:
A mortgage of $150,000 amortized over 25 years at 5% would result in a monthly payment of $872.41.
If we assume a 30% marginal tax rate on their income, their RRSP contribution would produce a tax refund of $2160 or $180/monthly. (For illustration purposes, I will use the monthly equivalent to keep everything on a monthly payment basis.)
If the rebate is applied to the mortgage, it is the equivalent of a monthly payment of $1,052.40, which would retire the mortgage in about 18 years (actual payment would be $1051.41).
At Age 60, the investor would have the following...
RRSP ($7,200 [$600/mo] x 30yrs x 5%) totaling $499,355
Non-RRSP investment [Mortgage payment available once mortgage retired] ($1051/mo x 12yrs x 5% @ 30% marginal tax rate) totaling $187,750.
In this scenario, the total accumulated by age 60 would be $687,105. Against this would be the interest cost for the mortgage of $76,866 for a net gain of $610,239.
Apply the full RRSP contribution to prepaying the mortgage:
Mortgage payments would be $872.41 + $600.00 or $1,472.41/mo. Which would see the mortgage retired in about 11 years. (Actual payment would be $1,475.87)
That would leave 19 years in which to invest in the RRSP ($7,200 [$600/mo] x 19yrs x 5%) for a total of $227,608.
The investor would also be able to invest the difference between the mortgage payment of $1,475.87 and the RRSP contribution of $600 into a non-taxable account ($875.87/mo x 19yrs x 5% less 30% marginal tax) for a total of $282,783.
In this scenario, the total accumulated by age 60 would be $510,391. Against this would be the interest cost for the mortgage of $44,814 for a net gain of $465,577.
This assumes that you have $7,200 to invest in the mortgage, just as you would in the RRSP. In fact, if you have $7,200 pre-tax income, you would only have $5,040 ($420/mo)after taxes with which to pay down the mortgage. Mortgage payments would therefore be $872.41 + $420.00 or $1,292.41/mo. which would see the mortgage retired in about 13 years. (Actual payment would be $1,305.68)
That would leave 17 years in which to invest in the RRSP ($7,200 [$600/mo] x 17yrs x 5%) for a total of $192,315.
The investor would also be able to invest the difference between the mortgage payment of $1,294.41 and the RRSP contribution of $600 into a non-taxable account ($872.41/mo x 17yrs x 5% less 30% marginal tax) for a total of $242,603.
In this scenario, the total accumulated by age 60 would be $434,918. Against this would be the interest cost for the mortgage of $53,687 for a net gain of $381,231.
1) Allowing the mortgage to pay off as scheduled, contributing the maximum to the RRSP and investing the rebate in a taxable account will produce an investment of $502,007.
2) Making the maximum RRSP contribution and applying the rebate as a prepayment to the mortgage which, once retired, will allow the tax rebates to be invested in a taxable account, will result in an investment of $610,239.
3a) Using the potential RRSP contribution of $7,200 to prepay the mortgage which, once retired, will allow contributions to an RRSP and investing the tax rebates to a taxable account will produce an investment of $465,577.
3b) However, as I have shown if you allow that you can use only post tax dollars for this payment, you are more likely to end up with $381,231.
On the face of it, the tactic of applying the tax rebates to the mortgage will result in the best results. There are of course a lot of variables. The level of individual income, company pensions or DPSPs, marginal tax rates, growing RRSP contribution levels, growing income, inflation rates and some I haven't though of here. And how many of us can actually save 18% of our income. And of course, these scenarios don't consider if someone earning $40,000 could even get a $150,000 mortgage. I don't however, believe that these factors affect the credibility of the illustrations from a pure calculation standpoint.
There is also the question of taxes on the RRSP portion when withdrawn. These may be higher or lower than the tax rate when the contributions were made and this could have a significant impact on just how much you will actually end up with in your pocket.
Further, it must be remembered that the house will make the same return on investment regardless of whether it has a mortgage against it or is free and clear. If you apply the mortgage interest against the RRSP and Non-Registered account, whatever capital gain/loss on the house it will be unaffected.
Never the less, I believe that the best scenario is number 2 above. It also points out that if you can start out early, even a modest rate of return can produce excellent results.
As I have posted before, it is not hard to get rich......... SLOWLY.
By the way, I used the Investment Calculators available at Altamira Financial Services to help me with these calculations. http://www.altamira.com/altamira/investment+calculators/index.htm
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