As the deadline for contributing to RRSPs for 2010 approaches, the long-standing debate between contributing to RRSPs or paying down a mortgage heats up once again.  Since 2009, the debate has expanded, as contributions to a TFSA must also be considered.  In an ideal world, RRSP and TFSA contributions would be maximized and there would be no mortgage to consider – not everyone is fortunate enough, however, to live in such a world, and as such, many must choose between contributions to RRSPs or TFSAs or paying down their mortgage - or a combination of the alternatives.

Identical rates of return can be earned within an RRSP or TFSA as the same investments may be made by each vehicle.  From a tax perspective, current and future tax rates are the key distinguishing features between RRSPs and TFSAs as an RRSP is funded with pre-tax dollars but subject to tax on withdrawal and a TFSA is funded with after-tax dollars but not subject to tax on withdrawal.  Generally, if the current rate of tax exceeds the tax rate upon withdrawal from the RRSP, contributing to an RRSP is favourable; conversely, if the current tax rate is less than the tax rate upon withdrawal from the RRSP, contributing to a TFSA is favourable. 

Example 1: 

Mr. X, with a current tax rate of 40%, can contribute $10,000 to an RRSP or $6,000 to a TFSA.  He can earn income annually at 5% in both the RRSP and TFSA.  At the end of year 10, the RRSP will be valued at $16,288.95 (prior to being taxed upon withdrawal) while the TFSA will be valued at $9,773.37.  If Mr. X is subject to tax at 40% upon withdrawal, the RRSP will be valued at $9,773.37 after tax (the same as if he had contributed to a TFSA); if Mr. X is subject to a lower tax rate upon withdrawal (35%, for example), the RRSP will be valued at $10,587.82 after tax; and if Mr. X is subject to a higher tax rate upon withdrawal (45% for example), the RRSP will be valued at $8,958.92 after tax.

When comparing contributions to RRSPs and TFSAs, other factors must also be considered, including the accessibility of TFSA funds before retirement (without tax consequences and with a restoration of the contribution limit), the impact that RRSP withdrawals will have on government benefits upon withdrawal, and a mandatory maturity only with respect to RRSPs. 

If current and future tax rates are the same, the decision of whether to invest in an RRSP/TFSA or pay down a mortgage will in large part come down to the rate at which income can be earned in the RRSP/TFSA and the “effective” mortgage interest rate (which takes the deductibility of such interest, where applicable, into account).  Generally, if an RRSP/TFSA can earn income at a higher rate than the effective mortgage interest rate, contributing to an RRSP/TFSA is favourbale; if an RRSP/TFSA earns income at a lower rate than the effective mortgage interest rate, paying down the mortgage is favourable. 

Example 2: 

If Mr. X’s current and future tax rates are the same, the RRSP/TFSA will be worth $9,773.37 at the end of year 10.  Assume Mr. X’s “effective” mortgage rate is fixed at 5%.

If Mr. X pays down his mortgage by $6,000, every year he will save $300 in interest expenses on his mortgage, which he can invest in an RRSP/TFSA and earn 5% or further pay down his mortgage and save 5%. If he invests the interest expense savings in an RRSP/TFSA, he will earn $773.37 of income, which combined with the contributions of capital to the RRSP/TFSA ($3,000) and the $6,000 additional capital in his house totals $9,773.37.  If Mr. X further pays down his mortgage with the interest expense savings, he will save $773.37 of interest expenses, which combined with the additional capital in his house ($9,000) totals $9,773.37. 

Had Mr. X’s effective mortgage rate been lower (4.5% for example), each year Mr. X would save $270 in interest charges on his mortgage, which he can invest in an RRSP/TFSA and earn 5%. At the end of year 10, Mr. X will have saved $2,700 in interest expenses, will have earned $696.03 of income in the RRSP/TFSA, and will have $6,000 additional capital in his house – for a total of $9,396.01. 

Finally, had Mr. X’s effective mortgage rate been higher (5.5% for example), each year Mr. X would save $330 in interest charges on his mortgage, which he can apply against his mortgage and save additional interest expense at a rate of 5.5%. At the end of year 10, Mr. X will have saved an additional $948.87 of interest expenses, which combined with the additional capital in his house ($9,300) totals $10,248.87.  Note:  further income may be earned by contributing the additional interest expense savings to an RRSP/TFSA, but this is ignored for the purposes of this example. 

When comparing a contribution to an RRSP/TFSA or paying down a mortgage, additional factors must again be considered, including the psychology of eliminating debt, “risk-free” savings (where the mortgage is fixed, one would know exactly what is being saved), and limits regarding mortgage principal repayments (both in terms of amounts and number of paydowns).

The guidelines above for choosing between contributions to an RRSP, a TFSA or paying down a mortgage are just those: guidelines.  In light of the inherent difficulty of predicting future rates of return, future tax rates and future mortgage rates (especially where the rate is floating), there is no clear answer to the debate.  Accordingly, individual circumstances and preferences must be taken into consideration, and in some cases, the optimal choice may in fact be a mix of the three different alternatives.