TO RRSP OR NOT?

It’s an age old question that has never had a clear answer: what to do with extra money - pay down a loan/mortgage, contribute to your RRSP, or invest it elsewhere outside of your RRSP? Why no clear answers? We have lots of data on capital markets that quantifies the benefits of investing in stocks (i.e. higher returns) and diversification (i.e. better risk/return tradeoff). But this question has a personalized answer for each individual and, to date, there has been no evaluation method that has been universally accepted for developing client solutions. This report will look at solutions to this question using some rules of thumb and case scenarios to help answer this question and provide guidance on the appropriate course of action.

Many financial planners, consultants and personal finance columnists have looked at this question and come to the conclusion that one should contribute to a RRSP, then use the tax savings to pay down the mortgage. The truth is that’s often the best thing to do, but we’ll back that up with hard numbers. Talbot Stevens has taken a unique (and very useful) approach - comparing alternatives on the basis of the after-tax income generated during the retirement years. The discussion that follows is similar to Mr. Stevens’ work since it will look at this decision in the context of after-tax rates of return throughout the lifetime of the alternative. It’s really just a simpler way of illustrating the same thing. In this age of mass mutual fund advertising, people are familiar with (and can easily comprehend) rates of return. More specifically, I will look at the annualized after-tax rates of return of various alternatives - paying down a loan/mortgage, contributing to a RRSP, and investing outside of the RRSP - and help you determine what’s best in different situations.

If we are talking about the wonderful problem of what to do with extra cash, I’m assuming that you’ve already taken care of those issues that are typically of highest order. I’m talking about setting up disability insurance, establishing an emergency fund (or emergency line of credit), putting appropriate life insurance policies in place, and getting wills and powers of attorney completed. Add up those financial priorities and you’re looking at a pretty sum of cash. But this analysis assumes that those things have already been implemented and additional money is suddenly available - from an inheritance, a bonus from work, or a chequing account that has gradually grown to a level too high to leave idle. That said, let’s take a look at how to decide what is best.

There are a few tests that you can run that can tell you to pay down a loan with whatever amount of extra money you have available. It’s the Debt Overload test and there are a couple of parts to it. First, calculate your debt service ratios to see if you’re already carrying an excess amount of debt. Neither the Total Debt Service (TDS)¹ nor the Total Debt Service Ratio (TDSR)² should exceed 32% of gross income. Also, the Gross Debt Service Ratio (GDSR)³ should not exceed 42% of gross income. These are general guidelines, but I like to use net income as the basis for calculating those ratios. After all, many middle-income people will have an average tax rate of 23% to 26%. If 42% of their gross income is earmarked for debt payments, that amounts to 55% to 57% of actual cash flow.

Second, look at the Debt-to-Asset ratio. Take the total of all debts and divide by the value of total assets. If the ratio is more than 0.50, you may have too much debt. If you seem to be suffering from debt overload, don’t worry about the rates of return, just bring that debt load down to a manageable size before looking to RRSP contributions or other investment opportunities. The cash flow that is freed up by repaying debt can be used for other purposes (or to simply pay down more debt if necessary). Remember that debt repayment is the equivalent of a guaranteed return.

One more test that should be used, though not at all mathematically-based, is simply your comfort level. Some individuals simply don’t like carrying debt. Although the numbers might say debt repayment isn’t the optimal choice, your chosen strategy must strike a balance between maximizing after-tax returns and fitting within your comfort zone.

If all things point to a very low or comfortable level of debt, then the decision should turn to the numbers. Let’s now take a look at how the different alternatives measure up.

The RRSP has three main benefits - the immediate tax deduction at a relatively high tax rate, long-term tax deferred growth, and withdrawals much later at an often lower tax rate. Despite all of these nice benefits, there remains one key to making the RRSP alternative worthwhile in the long run. What you do with the tax savings resulting from the initial contribution can make or break this decision. So, in calculating the annualized after-tax rate of return of the RRSP decision, we must look at many factors. In Table I below, annualized after-tax rates of return are illustrated for RRSP contributions at various rates of tax savings reinvestment. A balanced portfolio is assumed and a few things are worthy of note.

Though this won’t be news to any of you, notice the power of time. If you are able to put off withdrawing from your plan, that means you also defer the tax bill. The result is an enhanced after-tax return. Also, the larger the portion of tax savings put to productive use, the greater your after-tax return. Socking away all of the tax savings can add 3% or more annually to this alternative’s after-tax rate of return (actual impact depends on actual returns and individual tax rates).

Since some of you may be ultraconservative, the following Table II summarizes the same numbers for GIC or bond type returns.

It cannot be stressed enough how personalized these solutions need to be, but a couple of generalizations can be made as a guide.

Conservative clients are usually better off contributing to their RRSP.
This is the case for two main reasons. First, conservative clients will be largely invested in interest-generating securities. Since that interest in fully taxable, it is highly valuable to defer that tax as long as possible. During the accumulation years, investors will get hammered with high tax bills on interest generated on the entire non-registered portfolio - much of that during high-tax-rate years. Inside the RRSP, you not only gets to defer all interest during the accumulation phase, but you’re also able to re-invest any additional money "created" by the tax savings on RRSP contributions, thereby increasing long-term returns. Second, during those years when clients are using these interest generating investments for income, the non-registered portfolio continues to be taxed on all interest income generated on the entire portfolio. However, if drawing income from your RRSP, only amounts drawn down are taxable in any one year. While it’s true that in the RRSP both capital and interest lose their identities and become fully taxable when withdrawn, the RRSP’s sheltering power during the accumulation phase (especially during years of peak earnings and tax rates) more than offsets that cost. There are many factors specific to each client which will dictate what is best, but it’s safe to say that if your time horizon is under ten years, you are probably better off to keep the investment outside of the RRSP. If the time frame is much greater than ten years, there is a good chance the RRSP will provide valuable tax-deferral benefits.

If you’re more aggressive outside of your RRSP, the RRSP may not be for you.
The reasoning here is that most of an individual’s investable assets are tied up in RRSPs. Presumably, they are invested in a balanced portfolio and are constrained by the 25% (or 30% next year) foreign content limit. So, despite the increased availability of RRSP eligible foreign funds, most of the money invested in non-RRSP accounts is held in higher growth foreign equity investments. If this includes specialty investments, there is a good likelihood that a non-RRSP alternative will deliver a greater bang for you buck since capital gains are typically the main taxable component - most of which is deferred from taxes anyway. Higher return potential combined with reduced taxes on capital gains make the higher growth non-RRSP investments very attractive - especially for those in lower tax brackets.

The lower the tax bracket, the greater the potential benefit from non-registered investments.
Investments that either defer growth or throw off capital gains and/or Canadian-source dividends are a huge benefit to lower income individuals. Those in the lowest tax bracket still benefit greatly from Canadian-source dividend income, which is taxed at just over 6%, instead of interest which is taxed at the full marginal rate of 23%. However, if growth is the objective, investments generating capital gains will provide the greatest benefit, despite a lower retention rate than dividends.

The RRSP alternative remains the best option in most cases.
Tables I and III show that the RRSP provides a better after-tax return for a balanced portfolio compared to the same outside of a RRSP over a 20 year time frame and without any reinvested tax savings - 7.34% vs. 6.77%. If an apples-to-apples comparison is done the RRSP is almost always the best way to go. By "apples-to-apples" I mean buying the same investment inside and outside, as opposed to the reference above to more aggressive investors. Referring back to Table I shows that re-investing a mere 2/5 of the tax savings generated by a RRSP results in an after-tax return of 8.34% - a full percentage point higher.

Bob Smith is a young professional who has recently inherited $15,000. He is in the 46% marginal tax rate (he earns $60,000 per year), carries a comfortable debt load, and has $20,000 of RRSP carry-forward room. Here are Bob’s three choices:

1. The loan - Actually the mortgage is the only debt Bob has outstanding. He gets to deduct 10% of his mortgage interest since he does some work at home and his mortgage interest rate is 7% and he has 20 years left to pay.
2. The RRSP - Bob expects to earn 8% annually from his RRSP portfolio (60% equities and 40% fixed income) and will start withdrawing from it in about 20 years. (Despite the large contribution, we’ll assume for simplicity that the impact of the contribution will still be equal to his current 46% marginal tax rate.) He expects to be able to use 25% of the tax savings generated from the contribution to put towards one of these three choices.
3. The Non-RRSP Investment - Bob has a global equity fund that he would like to invest in and he expects that it will generate about 10% annually for the next 20 years.

In this case, it is actually more beneficial for Bob to invest that extra money into the global equity fund outside the RRSP. While that entails additional risk, there exists a realistic possibility of achieving that return if held for the full 20 years. For comparison purposes, Bob would have to re-invest at least 34% of the tax savings into the RRSP created by his RRSP contribution in order to beat the global equity fund alternative. Re-investing all of the tax savings back into the RRSP would result in an after-tax return of 10.58% per year. Finally, what about re-investing tax savings outside of the RRSP? Well, the maximum benefit in Bob’s situation would have come from making the RRSP contribution, then re-investing all of the tax savings into the global equity fund - resulting in an after-tax return of 11.09% per year.

This report and evaluation method is intended to provide you with greater insight into what most impacts the merits of the various alternatives. So while it does not address all the questions of all situations, I hope that it will enable you to make better decisions to enhance the tax-effective growth of your net worth.

And aside from all of the number crunching and examples illustrated in this report, you can’t go far wrong with making a RRSP contribution and using some or all of the tax savings to pay down on a loan. But in the end, human behaviour determines what’s best and you can’t put that into a formula.

In the near future, we’ll look at a couple of related topics: leveraging and the tax benefits of buy-and-hold funds.