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RRSP Tips and Common Questions

Should I Pay Down My Mortgage or Invest in an RRSP?

This question is one of the most common and one of the most important questions for an investor. When you are deciding between investing in an RRSP and paying down your mortgage, the best option depends on the risk of the investment income and the time until maturity on the investment income. With RRSP investments, you are effectively not taxed on your returns (since you receive a deduction from the contribution, the returns accumulate tax-free and you are then taxed on the eventual withdrawal, you effectively do not pay any tax). Therefore, you should probably invest in an RRSP whenever the return on the RRSP you are considering is higher than the interest rate you are paying on your mortgage, and vice versa. Most of the time, the only investment that represents a suitable alternative to paying down your mortgage is one that is held in your RRSP.

Riskiness of Investment

To make an accurate decision on whether you should prepay or invest, the RRSP investment you are considering must be of a similar risk to that of prepaying your mortgage. Since you know the risk of the mortgage (there is no risk to paying down your mortgage), and the benefits of paying it down (the return on paying it down is simply equal to the mortgage rate) you need to know the risk and the return on your investment to be certain about which is the better option. Examples of investments of which you can be fairly certain about risk and return include: government t-bills and bonds, corporate bonds that are of a high investment grade, GICs and term deposits. These investments have returns that are known in advance and you can be almost certain that there is no risk of not being repaid.
Stocks and Mutual funds are not of a similar risk to prepaying your mortgage. Their returns vary and you cannot be certain that you will be paid back on your investment. Therefore, not paying down your mortgage and investing in anything with an uncertain return, such as stocks and mutual funds, will put you in a riskier financial situation than prepaying or investing in something with a certain return. This does not mean that it should not be done. It just means that you should be aware of your increased risk. You should make such an investment only if you are a risk tolerant person and you should try to hold this investment for a relatively long period since holding for a longer period will reduce your risk (around five years). Again, if you do choose to invest rather than pay down your mortgage you should invest in an RRSP because of the preferential tax treatment.

The Home Buyer's Plan

“First Time Home Buyers” can withdraw up to $20,000 for a down payment on a “Qualifying Residence.” This withdrawal is not taxed as income and no interest is owed on those funds. In the second calendar year after your withdrawal, you must begin repaying a minimum of 1/15 of the withdrawal for every year. Therefore, you must fully repay your withdrawal after 15 years. These repayments are not tax deductible. If you pay less than the agreed upon amount in a certain year, you will be taxed on that amount. You may pay any amount over the required payment (you can fully repay the HBP as soon as you like) but you must pay at least the minimum amount. The Canada Customs and Revenue Agency will not allow a tax deduction for RRSP contributions that are made 90 days prior to being withdrawn for the Home Buyer's Plan if those funds are part of the withdrawal for the Plan.
To qualify as a “First Time Home Buyer,” you must: not own a home as a principal residence in the preceding four years and, if you are married, you must not be living in a house owned and occupied by your spouse. Disabled individuals automatically qualify for the Home Buyer's Plan.
A “Qualifying Residence” must be: located in Canada, not previously owned by you or your spouse, acquired by October 1 of the year following your withdrawal and intended to be your principal place of residence that you will actually occupy within a year of its acquisition.
The HBP is not only useful for those that don't have enough to make a down payment. Almost everyone can benefit from making a larger down payment since it means you will pay less interest over the course of the mortgage. Although you will lose the growth in your RRSP (since the money is withdrawn from there), the reduction in interest paid over the length of your mortgage will almost always be greater than the lost returns in your RRSP and therefore the HBP is a good strategy. The HBP is a good idea so long as the interest rate on your mortgage is higher than the return on the RRSP investments that you are withdrawing the funds from.

Getting the Cash to Make Your Contribution and RRSP Loans

There are two suggestions for you if you can't seem to find the cash for your contributions.

First, try making monthly contributions in the future. Most financial institutions will accept such contributions but you must be careful that your total value of contributions during the year won't exceed your contribution limit. This has two benefits: ensuring that you won't be stuck for cash around the contribution deadline and you will allow your returns to compound for a longer period creating higher returns in your RRSP (making contributions earlier in the year means they will have a longer period to earn a return for you).

The second suggestion is for you to consider an RRSP loan. An RRSP loan is a loan taken out to make your contribution and it is usually secured by the investment that you purchase with the loan (a term deposit or mutual fund for example). This is similar to making monthly contributions except that with a loan you obviously pay interest on top of your contribution. But there are two main benefits to taking out an RRSP loan: the returns on your investment will start to compound sooner (compared to if you contributed later to the RRSP) and you can get your tax deduction now as opposed to later. Naturally, you must ensure that you have an adequate cash flow and not so much debt that you can't service an RRSP loan, so see your financial advisor or bank loan officer.
Taking out an RRSP loan is usually a good idea. However, be sure that your interest rate is somewhere around the prime rate and make sure that you only take out an RRSP loan once. As soon as you take out the loan, start making periodic contributions to your RRSP, as this will have the same effect as taking out a loan except that you will not have to pay interest. Your financial institution should be able to help you here by automatically debiting your account on a regular basis and putting that amount in an RRSP.

Advantages of RRSPs

Some of the benefits of using an RRSP as opposed to other investment vehicles include:

• Getting a tax deduction on contributions
• Sheltering investments from taxation
• Deferring tax until your retirement years at which time you will probably be in a lower tax bracket
• Income splitting opportunities with spousal RRSPs
• Sheltering certain types of lump sum transfers from tax (i.e. retiring allowances)
• Greater flexibility with retirement income options

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