To Put Money Down on a House...Or To Fill a Very Empty RRSP?

[Octavius]

Hello Financial Experts

Here is the situation....

My parents recently separated and my father racked up A LOT of debt. My mother and I sold our home to pay it all off (as it was under his name as well) and she and I purchased a new, smaller home that we could both afford.

From the proceeds of the house, we have something around 40-50k being held in trust.

Essentially, our home was purchased for 230k and we put an 80k down payment on it. My mom STARTED her RRSP LAST MONTH (she is currently in her late 40's) only because I gave her the money to start her off and forced her to go into the bank to talk to an adviser.

So her RRSP is basically empty right now. What should we do? Should we take the cash and throw it all into the home to pay off the mortgage as fast as possible (I'm thinking this might be the best way to go), OR should she max out her RRSP and keep the mortgage the way it is?

We have a 5 year mortgage term right now, but we're allowed to put something like 15% down once a year without penalty.

Any ideas from financial gurus are much appreciated ;)

[ElChico]

It would depend on income. It might not make sense for your Mom to start an RRSP so late.

[Octavius]

It would depend on income. It might not make sense for your Mom to start an RRSP so late.

I agree, it sucks that she waiting this long. But unfortunately, it could not be helped.

She makes anywhere from 40k-50k / year (give or take)

[blexann]

It would depend on income. It might not make sense for your Mom to start an RRSP so late.

40's is NOT too late!..in fact neither is 50's for that matter since you can't convert the RRSP to a RRIF unitl I believe 69 anyway so lots of room for the money to grow sheltered inside an RRSP.

[blexann]

Hello Financial Experts

Here is the situation....

My parents recently separated and my father racked up A LOT of debt. My mother and I sold our home to pay it all off (as it was under his name as well) and she and I purchased a new, smaller home that we could both afford.

From the proceeds of the house, we have something around 40-50k being held in trust.

Essentially, our home was purchased for 230k and we put an 80k down payment on it. My mom STARTED her RRSP LAST MONTH (she is currently in her late 40's) only because I gave her the money to start her off and forced her to go into the bank to talk to an adviser.

So her RRSP is basically empty right now. What should we do? Should we take the cash and throw it all into the home to pay off the mortgage as fast as possible (I'm thinking this might be the best way to go), OR should she max out her RRSP and keep the mortgage the way it is?

We have a 5 year mortgage term right now, but we're allowed to put something like 15% down once a year without penalty.

Any ideas from financial gurus are much appreciated ;)

I'm no guru....but I would start contributing to an RRSP especially if there are no other debts - except for the mortgage which you hopefully you were able to get at a low interest rate(?)

Note - this is just my opinion so you may want to consult with a financial advisor

[pitz]

Paying down a mortgage provides a guaranteed, tax-free return of at least 5%. Imputed income from a principal residence is not taxable, while RRSP/RRIF income is taxed usually at fairly high incremental rates.

With a paid-up home in good condition, one can live reasonably well on CPP/OAS, and pay a minimum in income tax and still be eligible for plenty of social programs.

Personally my opinion would be to pay down the mortgage ASAP, as its probably fairly unlikely, IMHO, that given the circumstances, one could achieve a better lifestyle in retirement through RRSP investment. Especially if done so through an 'advisor' in typical high-MER mutual funds.

Needless to say, if she does go the RRSP route, she needs to be in 100% equities. Any bond allocation recommended through an asset allocation model should instead be redirected towards accelerated mortgage paydown.

[danfromwaterloo]

Calculate it.

Figure out how much you end up saving over the course of a mortgage by tossing it into your mortgage versus getting 6-7% in a RRSP.

[don242]

Put the money in the RRSP. Most financial advisors will suggest this as well.

First, you should be making a higher rate on your investment than your mortgage rate (especially these days) and second, you get the tax benefits from the RRSP, which if you want, you can then use to pay down your mortgage.

Or you could get a lot more complicated and head down the other routse of ideas such as the smith manouvre (paying your mortgage and then reborrowing for your home equity to invest) but I would suggest expert help for this.

[Bullseye]

I'm going to second Pitz's suggestion on this one, pay down the mortgage for the guaranteed return. In certain situations, it's better to go into retirement with no other income except CPP and OAS to prevent being means tested out of some low income goodies by having a small RRSP that is being drawed on. If she has extra money after paying off the mortgage, she should then invest outside an RRSP for the same reason.

I disagree with Dan and Don that it'll be easy to achieve investment rates of return higher than current mortgage rates in coming years. Bank stocks have returned 25% per year over the past four years, I don't see much room for further price growth anywhere near those levels for the next few years. Obviously, this is just my opinion.

Besides, even if I am wrong, this woman is too close to retirement age to do the heavy weighting in equities that would be required to achieve the higher returns.

On a personal note, my grandmother is 75, and lives on her own in Vancouver. She was always poor, but did manage to pay off her very modest home, and she now lives solely on CPP/OAS and the GIS given to low income folks. She also gets free prescriptions, a heavily subsidized bus pass, property tax deferrment, and other 'safety net' types of benefits. She has a HELOC in place for 'surprise' expenses and to just allow her to not worry about money. She feels she lives well enough, she says she actually has a higher standard of living now than when she was working.

So tell your mother not to fret too much. All those retirement articles saying you need millions to retire without having to eat cat food to survive ignore a lot of factors. A paid off house is the key factor here, and she should have that by retirement age.

Other considerations, though;

Did she work enough in her life to qualify for decent CPP pension?
Will she work past 65?
Will she sell and move later in life?

[pitz]

Most financial advisors have a conflict of interest as well in making such a recommendation, to wit: the advisor is paid to sell investments, but doesn't receive a commission/MER if you merely pay down a mortgage instead.

Not many advisors are sophisticated enough insofar as tax planning and benefits optimization in order to accurately model the whole calculus between a RRSP contribution (and eventual RRIF withdrawal) versus a mortgage pre-payment.

To add insult to injury, most advisors in such circumstances will probably recommend that one purchases a portfolio with fixed-income component when, in fact, mortgage paydown accomplishes the same thing, at far less cost, risk, and greater after-tax yield. And charge you 2% to boot for it all.


First, you should be making a higher rate on your investment than your mortgage rate (especially these days) and second, you get the tax benefits from the RRSP, which if you want, you can then use to pay down your mortgage.


You do realize that those purported 'tax benefits' are subject to repayment when the money is withdrawn, do you? You have to analyze both sides of the equation (few financial 'advisors' aka salesmen ever do), especially in the context of the very high incremental tax rates (and foregone social benefits) that most lower-income senior citizens face.

Or you could get a lot more complicated and head down the other routse of ideas such as the smith manouvre (paying your mortgage and then reborrowing for your home equity to invest) but I would suggest expert help for this.

This might not actually be that bad of an idea overall. Done with tax and fee efficient ETFs, a tax (and social-benefit-efficient) portfolio could be accumulated which would provide a modest augmentation of CPP/OAS, while, if executed properly, could consist mainly of Return of Capital and tax-efficient capital gains for a significant number of years.

The point I am trying to make here is that the question is a rather complicated one. Most professionals (not your typical mutual fund salesmen, but professional accountants, etc.) advise eliminating non-tax-deductible debt as soon as possible, and then investing into a RRSP using cash and a non-registered portfolio using deductible debt. Obviously if you don't have resources for a multiplicity of options, you have to prioritize, but having a fully-paid-up house is generally a very good idea for a majority of Canadians going into retirement.

[rfdrfd]

(This is only my opinion, and I'm not a financial expert here)

To me, debt is just bad. Any debt. Yes, some people say there is GOOD debt, but wait till the money maker of the house gets into a car accident, or gets really sick, or cancer, etc. Or company lays off 500 workers. I've seen all this happen the last few months to my friends. It ain't funny when it happens.

So, to me, reduce your debt is the biggest goal. Pay off your mortgage asap and at every chance you can get.

RRSP to me, doesn't really matter. Yes it defers taxes, but if you can have enough money outside RRSP, then its the same thing. Both are there for future retirement use. But if you have debt and money to repay, it is simply eating away at any profit or money you earn.

When you are 100% debt free, imagine every dollar you earn (after taxes) is yours to save and invest.

I know its a very simplistic way of viewing things, but if something happens to me (sick, died), I don't want my wife, kids or parents to hav to pay for anything. They will be sad (i hope, hehe), but they will continue to live normally. House is paid for, car is paid for, etc.

[ElChico]

I agree, it sucks that she waiting this long. But unfortunately, it could not be helped.

She makes anywhere from 40k-50k / year (give or take)

40-50?

Put into RRSP and take the tax refund, and put that into the mortgage :)

2 birds so to speak.

[nadeemhasan]

40-50?

Put into RRSP and take the tax refund, and put that into the mortgage :)

2 birds so to speak.

That's precisely what I would do too.

[blexann]

40-50?

Put into RRSP and take the tax refund, and put that into the mortgage :)

2 birds so to speak.

That's what I see - It's not complicated

[Bullseye]

That's what I see - It's not complicated

Actually, it IS more complicated than that, sorry. See my post and Pitz's for the reasons why.

[grant]

40-50?

Put into RRSP and take the tax refund, and put that into the mortgage :)

2 birds so to speak.
That's inefficient. The must lucrative option will always be either: use all funds to pay off mortgage, or put all funds (including tax refunds) into RRSP.

A smart person will obtain a carefully calculated low-interest loan to make the maximum RRSP contribution, and then use the refund to repay the loan.

[i6s1]

Smith Manuvre!!

Take the 50K and pay down your morgage. Then borrow 50K from the bank and put it an RRSP.

Now you have the 50K in the RRSP, where it creates a tax refund and grows tax free. And you've also changed 50K of your morgage to a loan that's tax deductable.

Option 1, put it in RRSP, Non Smith:

150k morgage at x%, non-tax deductable
50K in RRSP, plus tax write off (30% of 50k)

Option 2, put it RRSP, Smith:

100K morgage at x%, non-tax deductable
50K rrsp loan at y%, tax deductable interest, which means that y is less then x.
50K in RRSP, plus tax write off (30% of 50K)

But make sure that you don't use the RRSP tax return all in one year, spread it out. Just write off what you need to get down to the next tax bracket. it's better to get 30% back next year than 20% this year.

[pitz]

Now you have the 50K in the RRSP, where it creates a tax refund and grows tax free. And you've also changed 50K of your morgage to a loan that's tax deductable.


Wrong. Interest on money borrowed to invest in a RRSP is not tax deductible.

[ElChico]

That's inefficient. The must lucrative option will always be either: use all funds to pay off mortgage, or put all funds (including tax refunds) into RRSP.

A smart person will obtain a carefully calculated low-interest loan to make the maximum RRSP contribution, and then use the refund to repay the loan.

Something to consider is if everything was put into RRSP, with ~15 years to retirement, if there is a downturn in the economy, there will not be enough time to recover lost capital. Doing all one or the other exposes the person to too much risk in a short a time frame.

[circa76]

*sigh* I can't believe that no matter how many times its been explained people still don't understand how to use the Smith Manouvre.. anyway.. back on track..

Monthly Mortgage (150K @ 6%): $959
Monthly Mortgage (100K @ 6%): $639
Savings: $320

That $320 a month put into an RRSP (~ $3800/yr) may get her back $1100 in April. Put that into the RRSP for the next year as well, which means she'll get about $1400 back. Rinse and Repeat.

Assuming that she's got about 20-25 yrs to before retirement, her RRSP should be well over $120K (assuming she just stuffs this money into her mattress - too much to calculate otherwise, anyone wanna take a stab at it?), enough to pay off whatever the balance of the mortgage at retirement (which will be $0 in 25 yrs) and along with CPP and OAS, should be able to live alright (assuming no other debt)

oh yeah, I forgot inflation.. ok.. shove the RRSPs into a money market fund or something that will at least keep up with inflation

[pitz]

Assuming that she's got about 20-25 yrs to before retirement, her RRSP should be well over $120K (assuming she just stuffs this money into her mattress - too much to calculate otherwise, anyone wanna take a stab at it?), enough to pay off whatever the balance of the mortgage at retirement (which will be $0 in 25 yrs) and along with CPP and OAS, should be able to live alright (assuming no other debt)

oh yeah, I forgot inflation.. ok.. shove the RRSPs into a money market fund or something that will at least keep up with inflation

Ummm why not just accelerate the payoff of the mortgage? The return on paying off the mortgage surely will beat the crap out of a money market fund, and the returns from mortgage paydown will never be taxed upon withdrawal (unlike a RRSP).

Plus, a RRSP of 'only' $120k in 20 years will be the equivilant of $60k today, in other words, meagre. And unless tax policy changes, the $3-$5k (in today's dollars) that can be withdrawn from said RRSP will attract effective tax rates (tax + clawback + loss of benefits) greater than 50%.

And a 50-year-old does *not* have 25 years until retirement. The average Canadian dies at around 80 or so.

Why are the posters here so obsessed with RRSPs? Are you all brainwashed by the financial industry and devoid of mathematical ability and knowledge of the regressive implementation of Canadian social programs?

[circa76]

Ummm why not just accelerate the payoff of the mortgage? The return on paying off the mortgage surely will beat the crap out of a money market fund, and the returns from mortgage paydown will never be taxed upon withdrawal (unlike a RRSP).

Plus, a RRSP of 'only' $120k in 20 years will be the equivilant of $60k today, in other words, meagre. And unless tax policy changes, the $3-$5k (in today's dollars) that can be withdrawn from said RRSP will attract effective tax rates (tax + clawback + loss of benefits) greater than 50%.

And a 50-year-old does *not* have 25 years until retirement. The average Canadian dies at around 80 or so.

Why are the posters here so obsessed with RRSPs? Are you all brainwashed by the financial industry and devoid of mathematical ability and knowledge of the regressive implementation of Canadian social programs?

meh, I just tried to present a scenario whereby his mom would have the mortgage paid off and have some cash to live on as well.

And yes, I did mis-read the OP's original post.. he did say late 40's.. I just read 40's so I assumed she wouldn't be retiring until 65.

The $120K was supposed to be in today's dollars, inflation adjusted it would be about $250K (3%/yr 25yrs). Anyway, the point is moot since there isn't that much time left. So the mortgage paydown option would probably be the best with a reverse mortgage should your mom require extra funds.

[don242]

Pitz and Bullseye, I understand your points and they are good ones. However, she still has over 15 years till retirement. Definately not too late to invest in something that is going to give a higher return than the average mortgage rate.

And yes, I realize that a RRSP is just deferring your taxes, but by the sounds of it she will be deferring them until she retires and she has little income (the whole point of a RRSP). Why not get the tax break now and use that refund to pay your mortgage? 15 years is still plenty of time to pay down the mortage and contribute to a RRSP that will give you at least 7-8% annually.

Yes, I too like the idea of being debt free and I strive to maintain a debt free status. I do carry a mortgage, but I don't consider it a debt that needs to be paid off at this time. If interest rates change drastically upwards, I would make the mortage the priority, but that just doesn't seem to be the case any time soon.

Last thought, 50K a year may not be a large income but it is still adequate for covering general needs and enjoying your life and still have money left over to save (or pay off your mortgage). Take the lump sum now and invest and give it time to grow, use future income to pay off mortgage (it will be gone in 15 years by retirment).

[83_gemini]

Perverse as it is the tax system does weird things to low income seniors. Even a modest RRSP can lead to benefit clawback. Depending on her tax situation it may be best to have less income, not more, given the limited RRSP she will be able to amass.

[don242]

Perverse as it is the tax system does weird things to low income seniors. Even a modest RRSP can lead to benefit clawback. Depending on her tax situation it may be best to have less income, not more, given the limited RRSP she will be able to amass.

Is this true? I actually don't know much about CPP after retirment as it is quite awhile before it affects me, but I guess it would be a good idea to start gaining some understanding of what happens after retirement with regards to pension payments. I just always assumed (naively) that your pension payment is based on your contributions while you worked and is not affected by any income from your RRSP and savings.

[cannon_fodder]

I can certainly understand that RIF withdrawals will claw back the government supplements for low income seniors (e.g. GIS), but I was under the impression that, in today's dollars, you would have to earn almost $60k before the OAS was clawed. Further to that, I thought the CPP isn't affected by your income at all.

So, is it the case that if you ONLY have income of a few thousand you are hurt the most? I don't want to retire and try to only earn a few thousand just so I can receive full government benefits... I'd rather retire on $60k/year including CPP/OAS.

[circa76]

Is this true? I actually don't know much about CPP after retirment as it is quite awhile before it affects me, but I guess it would be a good idea to start gaining some understanding of what happens after retirement with regards to pension payments. I just always assumed (naively) that your pension payment is based on your contributions while you worked and is not affected by any income from your RRSP and savings.

There are clawbacks for GIS and OAS yes. Read about it here:
http://www.cbc.ca/news/background/personalfinance/clawbacks.html

[don242]

There are clawbacks for GIS and OAS yes. Read about it here:
http://www.cbc.ca/news/background/personalfinance/clawbacks.html

Thanks for the article. It was informative for my first general introduction regarding what happens after retirment.

So basically the cutbacks occur if you are making more than 60K. These aren't cutbacks to your CPP, only social assistance programs for those who do not have savings after retirment. So in the context of what was said earlier in the thread, I don't think these clawbacks really come into play. Like most social assistance programs, it is not sensible to plan to make less to benefit from the programs since you are most always ahead if you make enough you do not have to rely on these programs.

[83_gemini]

But OAS+GIS etc. is enough to live on (modestly). With the clawbacks in play, and if things go sour, the poor woman will have a mortgage to deal with and insufficient money to pay it off. After all you're taxed on your gross and have to live off your net.

By itself one cannot live off CPP. It is designed to be about 40-60% of your wages. Private sources are supposed to be bring up retirement income.

From the article mentioned above:

Since about half of GIS recipients pay income tax, the combined effect of paying tax on the RRSP payments and the reduction of GIS benefits results in an unexpectedly horrendous situation – an effective marginal tax rate of 75 per cent on those RRSP benefits. Call it a clawback by another name.

Little wonder that a 2003 study by the C.D. Howe Institute called RRSPs a "poor investment" for those at the lowest end of the income spectrum. Many groups are calling for Ottawa to bring in Tax Prepaid Savings Plans (TPSPs) as one solution to the GIS/RRSP clawback. Under TPSPs, contributions are not tax deductible. But when money is eventually withdrawn from these plans in retirement, it is tax-free.

People should also be aware that once the GIS disappears, so do some other benefits like drug and rent subsidies and provincial aid programs. For example, the one-time federal Energy Cost Benefit of $125 was sent to eligible seniors in early 2006 – but only to those who qualified for the GIS.

[cannon_fodder]

Thanks for the article. It was informative for my first general introduction regarding what happens after retirment.

So basically the cutbacks occur if you are making more than 60K. .

If you read the article again, you will see that GIS cutbacks happen at a much lower income (which makes sense since it is a supplement for low income seniors). The OAS cutback kicks in at just over $60k.

[Bullseye]

The key part of that article;

'Since about half of GIS recipients pay income tax, the combined effect of paying tax on the RRSP payments and the reduction of GIS benefits results in an unexpectedly horrendous situation – an effective marginal tax rate of 75 per cent on those RRSP benefits. Call it a clawback by another name.

Little wonder that a 2003 study by the C.D. Howe Institute called RRSPs a "poor investment" for those at the lowest end of the income spectrum. Many groups are calling for Ottawa to bring in Tax Prepaid Savings Plans (TPSPs) as one solution to the GIS/RRSP clawback. Under TPSPs, contributions are not tax deductible. But when money is eventually withdrawn from these plans in retirement, it is tax-free.

People should also be aware that once the GIS disappears, so do some other benefits like drug and rent subsidies and provincial aid programs. For example, the one-time federal Energy Cost Benefit of $125 was sent to eligible seniors in early 2006 – but only to those who qualified for the GIS.'

So in effect, a modest RRSP can be worse than no RRSP at all (because your effective marginal tax rate could be much higher than it was when you were working). This is why I recommend the OP's mother pay down the mortgage, then put money into non-registered investments after that. She can draw on the investments for income, but only pay taxes on the gains.

RRSP's are only good if you can be sure your tax rate will be lower in retirement. Depending on how much this woman could potentially accumulate in savings, her effective rate may indeed be higher. Especially as she doesn't appear to be a saver by nature.

[pitz]

So, is it the case that if you ONLY have income of a few thousand you are hurt the most? I don't want to retire and try to only earn a few thousand just so I can receive full government benefits... I'd rather retire on $60k/year including CPP/OAS.

Ideally you'd manipulate your finances in such a way that you gain access to wealth, but not have to actually call it 'income' for tax purposes. Focussing solely on 'income' , rather than wealth creation/building, can be downright dangerous (just ask income trust unitholders recently).

For instance, the imputed rent from owning a home with a paid-off mortgage provides a substantial return that cannot be taxed by the government because technically its not 'income' per se. The same home could also support a secured line of credit if additional augmentation is required -- also not called 'income' per se.

Non-registered investments can be pledged as collateral and borrowed against, again, not income, but spendable money nonetheless. Can't do that with a RRSP. In fact, the government dictates the schedule under which you can use your RRSP, and you are penalized if you do not use enough of it.

Take Mr. Warren Buffet, for example. His personal holdings consist primarily of a house, a car, and billions of dollars of Berkshire Hathaway stock (a stock that does not pay dividends). If he was a Canadian, and decided to retire as the manager of BRKA, Mr. Buffet could collect GIS/OAS/CPP/GST rebates, receive subsidized prescription drugs, and all the other perks. He could borrow literally billions of dollars against his holdings of Berkshire Hathaway, to indulge in a rich lifestyle, still receive Canadian welfare, and not pay much income tax. Pretty good scheme for a billionaire, eh?

Ideally you want to be Mr. Buffet, not some misguided person who is trying to 'retire' with some meagre RRSP savings and still paying off a mortgage. It is much more efficient, in the long run, to accumulate unencumbered equity, than it is to be shackled by the restraints of taxes and their very regressive nature.

[Xtreme2001]

Pitz, I always enjoy reading your posts. Very informative.

I have to complete my own research on this, but could you briefly tell me how borrowing against one's holdings works? Where would this be most beneficial? Are rates lower if you borrow against holdings? In your buffet example, how does he get away with everything, even though he has billions in one particular stock?

Thanks

[don242]

Great information everyone.

Obviously financial planning depends on each individual person's situation which makes it difficult to make any proper recommendations, but there has been lots to think about.

I do however, stand by my view that you should not plan to rely on social assistance programs (and the fact that millionaires can, shows not only the great planning by these people but also the flaws in a system that is meant to help those with less).

[Odysseus_Maximus]

Go to a casino:lol: :lol:

[majesus]

It is much more efficient, in the long run, to accumulate unencumbered equity, than it is to be shackled by the restraints of taxes and their very regressive nature.

WOW... VERY VERY solid point.
That's PITZ :)

[Bullseye]

I have to complete my own research on this, but could you briefly tell me how borrowing against one's holdings works? Where would this be most beneficial? Are rates lower if you borrow against holdings? In your buffet example, how does he get away with everything, even though he has billions in one particular stock?

Thanks

Non-registered investments are an asset, so they can be borrowed against, the lender simply puts a lien on them. This gets you a better interest rate. Some people use it to leverage even more investments, but in Pitz's theoretical example, an investor could also borrow against it to generate a non-taxable income stream.

Our tax system is flawed in the sense that it taxes income, not wealth, and that is what Pitz is highlighting. A similar real life example would be that guy who retired at 34 and wrote a book about it (Derek Foster - Stop Working). He has a half million in stocks and a paid off house, but he only lives on the dividend payments from those investments. Because dividends are taxed very favourably, he is able to live decently on fairly little. He also qualifies for many social benefits, because he is essentially 'low income', which adds to his standard of living (at taxpayers expense, mind you! But the ethics of that is for another post). So he's wealthy in assets, but 'poor' in income according to our tax system, because he's manipulated that system to work to his best benefit.

[mork]

This thread has been an interesting read. Something that occurs to me is that there is some assumption that the retiree is going to draw on their RRSP at a steady 'equalized' pace.

Could a retiree not just simply withdraw their entire RRSP, pay all taxes owed on it, and do whatever with the money (some non-RRSP investment vehicle).

Then.. in subsequent years of retirement they may have the ability to demonstrate a very low income, and as a result receive some of the government benefits discussed here.

Are there some constraints associated with RRSPs to prevent this?

I realize withdrawing the large sum in a single year would guarantee that it will be taxed at a higher rate, but perhaps there is some balancing point with the benefits realized in future low-income years?

[pitz]

This thread has been an interesting read. Something that occurs to me is that there is some assumption that the retiree is going to draw on their RRSP at a steady 'equalized' pace.

Could a retiree not just simply withdraw their entire RRSP, pay all taxes owed on it, and do whatever with the money (some non-RRSP investment vehicle).


The problem that then occurs is that the effective incremental rate of tax on the RRSP is elevated over its entire lifespan.

We can model taxation on RRSPs as follows:

eff tax rate = (1 - j + {[(1+j)*(1+k)^n]*(1-m)}^(1/n))/k

For RRSP holdings for n years, with an annualized return of k, and incremental tax rate of j at time of contribution, and incremental rate of m at time of withdrawal.

Obviously the computed savings associated with a RRSP is at its maximum when n=0, and the effective tax rate drops to 0 when n = infinity.

A 10-year-holding period on a RRSP still generates an average tax rate on RRSP investment greater than what one could achieve using tax-deferred non-RRSP equity investment. After 10 years, the effective tax rate on a RRSP for someone in the 40% tax bracket is still 20%. The same rate immediately achieved by investing in equitiees that produce capital gains. Of course, deferred capital gains follow a very similar curve.

So to achieve any tax savings in a RRSP, you have to hold for a very long period of time, in the order of at least 20 years, if not longer, just to equal the treatment of non-registered capital gains in terms of average annual tax rates.

So if one plans on cashing their RRSP out early in its entirety, not only do they end up paying at the top marginal rates (because their income is spiked), but they never do realize effective tax rates below what would have been achieved using a simple buy and hold non-registered stock strategy. Plus their money is locked up and cannot be leveraged to boot.

You're a physicist, so the math shouldn't be difficult, but private message me and I can send you a spreadsheet with the above calcs if you want.


Then.. in subsequent years of retirement they may have the ability to demonstrate a very low income, and as a result receive some of the government benefits discussed here.


Sure, but the question is one of optimization of current savings, and which structure is the most appropriate if it is likely that such a scenario is contemplated.


Are there some constraints associated with RRSPs to prevent this?


Not really. Some RRSPs/RRIFs are locked-in, however, and are subject to minimum and maximum yearly withdrawals under the Income Tax Act and provincial legislation. These plans are usually associated with commutation of a defined benefit pension plan, or are otherwise, workplace sponsored pensions.


I realize withdrawing the large sum in a single year would guarantee that it will be taxed at a higher rate, but perhaps there is some balancing point with the benefits realized in future low-income years?

There are always optimizations possible, but also keep in mind that tax policy is constantly shifting in Canada. Just a little more than a decade ago, capital gains were taxxed at the same rates as income. Now the Tories are talking about further reductions in capital gains taxes, and have implemented an enhanced tax credit associated with Canadian-sourced dividends. Also planning optimizations that might work in one set of market conditions, may not work in another (such as leverage).

[83_gemini]

Actually I think lower taxes on dividends and capital gains are good-they encourage investment. What's needed are effective consumption taxes combined with credits for those with low incomes, so people who are wealthy, live off dividens and consume rather then invest pay appropriate levels of tax.

Canada's tax system is not particularly progressive in any case; average rates are about 33% across the board, and marginal rates can be very wonky depending on income thresholds.

[cannon_fodder]

We can model taxation on RRSPs as follows:

eff tax rate = (1 - j + {[(1+j)*(1+k)^n]*(1-m)}^(1/n))/k

For RRSP holdings for n years, with an annualized return of k, and incremental tax rate of j at time of contribution, and incremental rate of m at time of withdrawal.

Obviously the computed savings associated with a RRSP is at its maximum when n=0, and the effective tax rate drops to 0 when n = infinity.

A 10-year-holding period on a RRSP still generates an average tax rate on RRSP investment greater than what one could achieve using tax-deferred non-RRSP equity investment. After 10 years, the effective tax rate on a RRSP for someone in the 40% tax bracket is still 20%. The same rate immediately achieved by investing in equitiees that produce capital gains. Of course, deferred capital gains follow a very similar curve.

So to achieve any tax savings in a RRSP, you have to hold for a very long period of time, in the order of at least 20 years, if not longer, just to equal the treatment of non-registered capital gains in terms of average annual tax rates.


Where did you find this formula? Do you know how it was justified? Does this factor in the tax refunds being reinvested?

Based on the above statement, it suggests that one might be better, as one nears retirement, to not invest in an RRSP. On the other hand, if you withdraw from your RRSP/RRIF for more than 20 years, one could always think that the last dollar in is the last dollar out - thus giving a rolling 20+ year window.

[pitz]

Where did you find this formula? Do you know how it was justified? Does this factor in the tax refunds being reinvested?


I developed the formula. Its pretty simple:

1) The amount of a RRSP contribution, on a pre-tax basis, is equal to (1+j)
2) That RRSP contribution compounds at the rate of k%/year, for n years, thus (1+j)*(1+k)^n
3) A withdrawal from the RRSP is made, and is taxed at the incremental rate of m%, in other words, leaving (1-m) of the value of the RRSP remaining.
4) Therefore, we can find the annualized rate by taking the result of (3), and finding the n-th root (ie: ^(1/n)).
5) This result can be expressed as a ratio of the rate of return, to thus determine a tax rate, by subtracting 1, and then dividing by the pre-tax rate of return, k.

Not quite grade 9 math, but not very difficult once you work through it.



Based on the above statement, it suggests that one might be better, as one nears retirement, to not invest in an RRSP. On the other hand, if you withdraw from your RRSP/RRIF for more than 20 years, one could always think that the last dollar in is the last dollar out - thus giving a rolling 20+ year window.

Indeed. RRSPs are a terrible investment if you buy, and only hold for 10 (or die within) 10 years, compared to tax-deferred equities.

Basically you need to optimize for conflicting goals. For example, young investors ultimately benefit the most from the long-term tax-deferred compounding of RRSPs, but they also tend to have the lowest tax rates. Whereas older investors often do not have enough time in order to make RRSPs worthwhile. Undoubtely there is a sweet spot, probably occurring in one's 30s and early 40s.

[pitz]

Here's a graphical view of RRSPs versus ideally tax efficient non-RRSPs for an individual who contributes at a 35% incremental tax rate, and withdraws at a 35% incremental tax rate:

http://pitzel.dyndns.org/RRSP.JPG

Note that one is clearly better off, return wise, with the non-RRSP investment until approximately 13 years has passed. Cashing out RRSPs earlier than 13 years is financially stupid.

And the two curves pretty much remain fairly converged after 13 years, which means you are not really extracting a premium for locking up your equity within the RRSP. Whereas, if you kept the equity outside of the RRSP, you could be using it to lower your cost of credit insofar as borrowing is concerned, and you could be applying leverage to your investments.

Of course, one is far worse off with the RRSP if they are paying a higher effective tax rate in the withdrawal phase than they were paying in the accumulation phase.

So aside from the short-term pyschological effect of saying 'up yours' to the taxman, there is little reason to accumulate anything but fixed income investments in a RRSP. And even then, if one has a mortgage, they shouldn't be buying fixed income anyways -- they should be merely paying down their mortgage, as it doesn't make sense to be simultaneously a lender, and a borrower, when borrowing costs significantly more than the returns on lending (due to varying credit spreads, or a flat/inverted yield curve).

edit: the graph also proves my other point, that only people in their 30s and early 40s should consider investing in RRSPs at all, over and above amounts that can be withdrawn under the HBP/LLP. If you invest in a RRSP when too young, you've locked up your money for all those years for no additional return (as the curves completely converge after 40 years anyways). If you invest in a RRSP when too close to retirement, you never do achieve the advantage of the tax deferral inside the RRSP.

a further note: non-RRSP savings can be accumulated in tranches, and removed on a LILO basis, highest cost-base first, so as to maximize long-term tax deferral, whereas no such optimization is possible on a RRSP. Borrowing can also be used to defer tax until death. This is not possible with RRSPs/RRIFs in the withdrawal phase.

[cannon_fodder]

I've checked twice, and I seem to have copied your formula exactly but it is giving answers which don't make sense so I must not be understanding the results. I would have expected an answer less than j but I'm getting answers in the 20's (i.e. I put in j=.463, k=0.08, m=0.32 and n=1 to 25).

Regardless, I would like to understand the following:


1) The amount of a RRSP contribution, on a pre-tax basis, is equal to (1+j)

Assuming incremental tax rate is marginal tax rate, why not equal to 1/(1-j)? The grossed up amount?

It is March 1st and I have $1k in my bank account. I can invest that in a non-registered account or I could borrow $666 and add that to my $1k and contribute it to my RRSP. I efile immediately and get my return about the 2nd week of March (except for the borrowing, this is what I do - if I had to pay taxes, I'd wait until April 30th to submit). My tax refund comes in, and because I'm in the 40% tax bracket, I get my $666 back which I use to pay down my loan. (Whether you actually get a loan or not I think is irrelevant, especially considering the interest on such a short lived loan would be about $1.67). So, I have $1,666 working for me in my RRSP as opposed to $1,400 or (1+j).
2) That RRSP contribution compounds at the rate of k%/year, for n years, thus (1+j)*(1+k)^n

In my scenario it would be (1/(1-j))*(1+k)^n

3) A withdrawal from the RRSP is made, and is taxed at the incremental rate of m%, in other words, leaving (1-m) of the value of the RRSP remaining.

I misinterpreted what you said here. In case anyone else does, in pitz assumptions, you are withdrawing the entire value of whatever the contribution grew to, e.g. if you contributed $1 and it grew to $3.45 you are withdrawing the entire amount. By saying "the value of the RRSP remaining" I thought pitz meant that there was some $ left in the RRSP after the withdrawal.

4) Therefore, we can find the annualized rate by taking the result of (3), and finding the n-th root (ie: ^(1/n)).

It would be helpful if you would be very specific. Remember, we don't all think like you and understand where you are coming from. You mean you get the annualized growth rate net of taxes do you not?

5) This result can be expressed as a ratio of the rate of return, to thus determine a tax rate, by subtracting 1, and then dividing by the pre-tax rate of return, k.

I'm tired so perhaps it is my error, but your description doesn't match the formula. Your formula adds 1 and subtracts j to/from the result after step 4 and then divides by k. Hopefully you can address what you are trying to achieve because at this point I'm not sure it matters.

The reason I say that is simple - if someone came to you and said they could put you in two investment solutions that would grow and your choice would be to pay no tax, or pay your marginal tax rate what would you want to know? After taxes, how much will I have in either scenario?

If after the 1st, 2nd, 3rd, nth years I have more money, after taxes, by investing in my RRSP versus a non-registered plan, isn't that a better measurement of investment success rather than which requires me to pay more taxes?

Based on breaking down your formula, it is clear that you end up with more money after taxes with the RRSP scenario unless your marginal tax rate when you deposit is significantly less than your marginal tax rate when you withdraw.

I believe whenever I've seen arguments in favour of non registered investing over RRSP's there are two (sometimes not explictly stated) premises:
1. The subject doesn't gross up their RRSP contribution or equivalently they don't reinvest the tax refund. In fact it is never used to do anything useful like pay down credit card debt, the mortgage, etc. It somehow "disappears".
2. The marginal tax rate differential between when the money goes in and comes out is nominal at best and, at worst, higher when coming out.

I hadn't taken the time to actually run some numbers as I always assumed RRSP's were the best first choice. The recent articles/posts warning about government benefit clawbacks and the tax advantage of non RRSP investing over RRSP investing had caused me concern. Now I feel more assured.

The unassailable advantage of an RRSP (as long as your marginal tax rates don't skyrocket from working to retirement) is the tax refund. Compounding tax free is a benefit on a downward sliding scale as one moves from interest producing investments to straight equities even turning negative if you have to sell at a loss.

I really appreciate (as do many others I'm sure) the time you take to post in this forum. It is good to have one's ideas challenged, get the mind thinking and not just accepting.

[cannon_fodder]

Here's a graphical view of RRSPs versus ideally tax efficient non-RRSPs for an individual who contributes at a 35% incremental tax rate, and withdraws at a 35% incremental tax rate:

Note that one is clearly better off, return wise, with the non-RRSP investment until approximately 13 years has passed. Cashing out RRSPs earlier than 13 years is financially stupid.

And the two curves pretty much remain fairly converged after 13 years, which means you are not really extracting a premium for locking up your equity within the RRSP. Whereas, if you kept the equity outside of the RRSP, you could be using it to lower your cost of credit insofar as borrowing is concerned, and you could be applying leverage to your investments.

Of course, one is far worse off with the RRSP if they are paying a higher effective tax rate in the withdrawal phase than they were paying in the accumulation phase.

So aside from the short-term pyschological effect of saying 'up yours' to the taxman, there is little reason to accumulate anything but fixed income investments in a RRSP. And even then, if one has a mortgage, they shouldn't be buying fixed income anyways -- they should be merely paying down their mortgage, as it doesn't make sense to be simultaneously a lender, and a borrower, when borrowing costs significantly more than the returns on lending (due to varying credit spreads, or a flat/inverted yield curve).

edit: the graph also proves my other point, that only people in their 30s and early 40s should consider investing in RRSPs at all, over and above amounts that can be withdrawn under the HBP/LLP. If you invest in a RRSP when too young, you've locked up your money for all those years for no additional return (as the curves completely converge after 40 years anyways). If you invest in a RRSP when too close to retirement, you never do achieve the advantage of the tax deferral inside the RRSP.

a further note: non-RRSP savings can be accumulated in tranches, and removed on a LILO basis, highest cost-base first, so as to maximize long-term tax deferral, whereas no such optimization is possible on a RRSP. Borrowing can also be used to defer tax until death. This is not possible with RRSPs/RRIFs in the withdrawal phase.

Beyond stating what I did in the previous post, your conclusion is based on a marginal tax rate that stays the same, i.e. does not get lower in retirement. I'd say that this is more likely the lower the tax bracket in which you are today, but less likely the higher the tax bracket in which you are today.

I like your point about the best fixed income investment whether in/out of an RRSP... it is called paying down your mortgage.

Based on the varied sophistication of the forum readers, and the good deal of credibility that is accorded you, it may be wise to be specific, and not general, when stating conclusions. Someone without a critical eye might look at your post and conclude that they should only invest in an RRSP if all of the following criteria are met (with possible relaxing of these 'rules' for HBP/LLP scenarios):

- you are in your 30's or 40's
- you leave it in for at least 13 years
- you will not have a higher marginal tax rate when retired as compared to working
- you have no mortgage
- you only buy interest income investments for your RRSP

If this is your recommendation then I'm sure it will be challenged without promise of consensus.

[nadeemhasan]

I know this may be a little off topic but if I have been contributing to my RRSP until I file my return by middle of Feb, get the refund, and apply that refund to the RRSP as a contribution, then file an amendment to the 2006 tax return for the new contribution. Could I keep doing this until March 1st occurs?

[cannon_fodder]

I know this may be a little off topic but if I have been contributing to my RRSP until I file my return by middle of Feb, get the refund, and apply that refund to the RRSP as a contribution, then file an amendment to the 2006 tax return for the new contribution. Could I keep doing this until March 1st occurs?

Why not take out a short term RRSP loan to top up or get you to the contribution level you want? Then you only have to submit one tax return.

[pitz]

Assuming incremental tax rate is marginal tax rate, why not equal to 1/(1-j)? The grossed up amount?


The assumption is that you will invest $1 in after-tax income, and then receive, immediately thereafter, a tax refund of j, that is then invested into the RRSP immediately. 1/(1-j) would be applicable if you were continously receiving your RRSP tax refund as you are making contributions, re-investing the refunds, and then further re-investing the refunds upon the refunds (ad nauseum) until you were receiving a penny of refund on pennies of contributions.

I guess, in theory, a reasonable approximation is possible, if you have your withholding adjusted through a T1213, or through direct payroll deduction.


It is March 1st and I have $1k in my bank account. I can invest that in a non-registered account or I could borrow $666 and add that to my $1k and contribute it to my RRSP. I efile immediately and get my return about the 2nd week of March (except for the borrowing, this is what I do - if I had to pay taxes, I'd wait until April 30th to submit). My tax refund comes in, and because I'm in the 40% tax bracket, I get my $666 back which I use to pay down my loan. (Whether you actually get a loan or not I think is irrelevant, especially considering the interest on such a short lived loan would be about $1.67). So, I have $1,666 working for me in my RRSP as opposed to $1,400 or (1+j).


Sure, you can do a one-off iteration of such. But unless you are doing that on a continuous basis, the effective amount of capital working for you will be closer to (1+j) than (1/(1-j)). Contributions aligned to your paycheques (or direct payroll deduction), with a corresponding reduction in withholding through the CRA T1213 interface, is obviously optimal.


In my scenario it would be (1/(1-j))*(1+k)^n


If you are optimized, continously receiving the refunds, and re-investing. The solution of 1/(1-j) mathematically equates to a continuous (and infinite) summation of the effects of continous investment and instantaneous refunds of tax.

So we're both right, although I maintain that, for private RRSP investors, the former, and not the latter scenario is the most likely.


I misinterpreted what you said here. In case anyone else does, in pitz assumptions, you are withdrawing the entire value of whatever the contribution grew to, e.g. if you contributed $1 and it grew to $3.45 you are withdrawing the entire amount. By saying "the value of the RRSP remaining" I thought pitz meant that there was some $ left in the RRSP after the withdrawal.


Well ultimately a RRSP/RRIF must be collapsed. The minimum withdrawal tables, and death, compel that. The effects of death are not taken into consideration with the simplistic analysis as presented earlier, but I would suggest that they are perhaps more severe with the RRSP (which, if left with any residual value, probably will spike one into the highest tax brackets), than they are with long-term capital gains that will only ever, at worst, be taxed at one half the highest tax bracket.



The reason I say that is simple - if someone came to you and said they could put you in two investment solutions that would grow and your choice would be to pay no tax, or pay your marginal tax rate what would you want to know? After taxes, how much will I have in either scenario?


Thats essentially what the graph I gave above computes. And its pretty obvious that short-term RRSP investment is very undesirable. The long-term case is only slightly better, at the expense of liquidity.



If after the 1st, 2nd, 3rd, nth years I have more money, after taxes, by investing in my RRSP versus a non-registered plan, isn't that a better measurement of investment success rather than which requires me to pay more taxes?


Sure. But we are talking about optimization here. Its fairly clear that in the short term, the RRSP will cause higher effective tax rates to be paid on equity investment than non-RRSP investment. And in the long-term, you are completely giving up liquidity and leveragability, in exchange for a mere few extra basis points of after-tax return.

The sweet spot therefore clearly lies in the medium term. Unfortunately, for most Canadians, this theoretical sweet spot lies during the phase in life when people have the least amount of disposible income. Most decent earners in their 30s have young families, consumer debt hangovers from their 20s, and the need to move out of some small condo, and into something a bit larger -- in other words, not much in terms of excess capital available for RRSP contributions at a time when they are most optimal.


Based on breaking down your formula, it is clear that you end up with more money after taxes with the RRSP scenario unless your marginal tax rate when you deposit is significantly less than your marginal tax rate when you withdraw.


For the very long term, true. But nothing that cannot be overcome with even a slight amount of leverage. Sure, you can leverage RRSPs as well, but the cost of capital for doing so is much higher because of the tax deductability.



I believe whenever I've seen arguments in favour of non registered investing over RRSP's there are two (sometimes not explictly stated) premises:
1. The subject doesn't gross up their RRSP contribution or equivalently they don't reinvest the tax refund. In fact it is never used to do anything useful like pay down credit card debt, the mortgage, etc. It somehow "disappears".
2. The marginal tax rate differential between when the money goes in and comes out is nominal at best and, at worst, higher when coming out.


I dealt with point 1) earlier. The result is somewhere between (1+j) and (1/(1-j)). And 2) was also dealt with earlier in this thread, to wit: most retirees won't see the promised savings in terms of marginal tax rates, due to social program benefit reductions (and at the high end, OAS clawback).


I hadn't taken the time to actually run some numbers as I always assumed RRSP's were the best first choice. The recent articles/posts warning about government benefit clawbacks and the tax advantage of non RRSP investing over RRSP investing had caused me concern. Now I feel more assured.


I think we can agree that RRSP's are not the huge windfall that the financial 'industry' portrays them to be. Each situation, obviously, is unique.

[controlyar]

The magic number is not 13 with respect to when investing in an RRSP is more beneficial versus non-registered investments. Every situation is different, however, 13, is a close approximation. (it is lower).

I have worked on many case studies and real-life examples to prove this.
It should also be considered that gains in an RRSP are taxed diferently than non-registered gains.

As Pitz suggests, the whole mortgage vs. RRSP debate is tricky. I have reviewed many cases where contributing to RRSPs is more beneficial versus paying down the mortgage quickly as possible. I am not sure why you have such a negative attitude towards financial professionals and their "myths." Did you have a bad experience? It is unfortunate how you are labeling the investment industry as a giant conflict of interest. Personally, I do not think that is very professional. And it is ironic how Pitz suggests paying down the mortgage is the best option in every case, when in other threads he mentions investing in real estate futures. :lol: Paying down the mortgage is a risk-free option, and investing in derivates can be very speculative. Which one is it? And relying solely on government benefits is quite ridiculous if you are willing to accept a lower standard of living. I am not sure how that came into the equation. If you pay off your mortage quickly, it is possible to build quite comfortable nest egg of non-registered (or registered) investments. I do not think clawback is really an issue. $60,000 is a substantial income when a client has zero debts. Unless, you are referring to GIS. And then again, what's the point of having tremendous assets if you aren't going to use them just to take advantage of gov't benefits.

Some interesting discussion though.

[pitz]

And it is ironic how Pitz suggests paying down the mortgage is the best option in every case, when in other threads he mentions investing in real estate futures. :lol: Paying down the mortgage is a risk-free option, and investing in derivates can be very speculative. Which one is it? And relying solely on government benefits is quite ridiculous if you are willing to accept a lower standard of living. I am not sure how that came into the equation.

Paying down a mortgage is not investing in real estate. Reducing debt is the equivilant of investing in a fixed-income instrument with an interest rate equivilant to that of the obligation (adjusted accordingly for taxes, of course).

Accumulating savings in housing futures for a housing purchase makes perfect sense and derivatives are an appropriate instrument to mitigate against volatility and to manage housing investment risk.

Insofar as the question of government benefits, the task at hand is to optimize one's savings for the highest standard of living in retirement. If this involves partially living off of the taxpayer's tit while being a millionaire, then so be it. The ethics and morality of doing so really should be a completely seperate discussion. Important, but if someone feels ethically bound, the Crown still accepts donations.

[Octavius]

My head is going to explode ;)

Very informative guys, you're all giving me a good idea as to which road might be the best one to travel on.

Pitz, extremely informative...but the talk of all those equations scares the ***** out of me ;)
I understand them and where you are coming from, but just....I hate equations =P
No biggie though, I know what you're saying.

Thanks to all for your input thus far. Keep posting :D

[don242]

My head is going to explode ;)

No biggie though, I know what you're saying.

Thanks to all for your input thus far. Keep posting :D

Glad someone is following all of this. I am only partially getting it. I keep getting lost in the equation. I still can't see how paying your mortgage off is better than investing the money. Mortgage = 5%, investment equals 8%. That alone seems to indicate investment is better.

However, I do see the manipulation of what is considered income after retirement as being a benefit so that you can take advantage of the social assistance programs.

Can someone reccomend some good books dealing with this sort of thing? I need to rethink my financial plan and if someone would be willing, I wouldn't mind some input regarding my current situation. If willing, please PM me. I would like to have some new ideas to contemplate.

[pitz]

Glad someone is following all of this. I am only partially getting it. I keep getting lost in the equation. I still can't see how paying your mortgage off is better than investing the money. Mortgage = 5%, investment equals 8%. That alone seems to indicate investment is better.

Its not that easy though, because the 5% associated with the mortgage payoff will not be taxed, while a 'risky' 8% associated with investment (the 8% may never materialize) in a RRSP will be taxed, and taxed heavily.

An optimal strategy, if leverage is acceptable, would be to pay down the mortgage, and then obtain a line of credit against the equity to invest with (into long-term equity investments).

We know from the math I presented earlier that non-RRSP investment and RRSP investment, over longer periods of time, have roughly similar investment returns. But if you borrow and invest outside the RRSP, you pay substantially less to borrow, and you gain a lot more flexibility and liquidity.


Can someone reccomend some good books dealing with this sort of thing? I need to rethink my financial plan and if someone would be willing, I wouldn't mind some input regarding my current situation. If willing, please PM me. I would like to have some new ideas to contemplate.

The rules of the game seem to change with each new Canadian government. The calculus of the entire game just changed again last month with Minister Flaherty's announcement concerning income trusts. Its really an area where subject manner expertise, and knowledge of current events is critical, if one is to be able to optimize accordingly.

PM me if you want.. But do seek a second, third, and/or fourth opinion.

[don242]

Its not that easy though, because the 5% associated with the mortgage payoff will not be taxed, while a 'risky' 8% associated with investment (the 8% may never materialize) in a RRSP will be taxed, and taxed heavily.



I understand your point here, but by investing early your returns are compounding from the time you start. Whereas paying off your mortgage and then begin investing 10 years later results in a lot of lost time for your investments to grow.

As for 8%, I agree it may never happen but if your investments are sound, 8% should be a relatively appropriate average return if you are managing your investments.

I am not disagreeing with you, just trying to understand better.

[controlyar]

I understand your point here, but by investing early your returns are compounding from the time you start. Whereas paying off your mortgage and then begin investing 10 years later results in a lot of lost time for your investments to grow.

As for 8%, I agree it may never happen but if your investments are sound, 8% should be a relatively appropriate average return if you are managing your investments.

I am not disagreeing with you, just trying to understand better.

Hello my fellow Cambridgian. :lol:
The reason why I PERSONALLY would invest versus pay down the mortgage is because I am very confident that I can earn 15% relatively easily (have no problems accepting "some risk", understand the ramifications of different investments, am an expert at creating portfolios, and have experience with the math aspects of the tradeoff). Different strokes for different folks.
For me, there is no comparison.

[neospice]

I understand your point here, but by investing early your returns are compounding from the time you start. Whereas paying off your mortgage and then begin investing 10 years later results in a lot of lost time for your investments to grow.

As for 8%, I agree it may never happen but if your investments are sound, 8% should be a relatively appropriate average return if you are managing your investments.

I am not disagreeing with you, just trying to understand better.

When you invest in an RRSP, you're right in that your returns are compounded annually. What do you think a mortgage does? It compounds annually as well... the less you put into it, the more it compounds and the more you end up owing the bank in the long run. What I think he's trying to say is that by putting money down on your mortgage you are effectively stemming the compounding of it. The difference being that when you take your money out from an RRSP it is coming out taxed heavily whereas the mortgage is simply paid off albeit with taxed income.

[cannon_fodder]

From pitz:
Thats essentially what the graph I gave above computes. And its pretty obvious that short-term RRSP investment is very undesirable. The long-term case is only slightly better, at the expense of liquidity.
and
We know from the math I presented earlier that non-RRSP investment and RRSP investment, over longer periods of time, have roughly similar investment returns.

For the very long term, true. But nothing that cannot be overcome with even a slight amount of leverage. Sure, you can leverage RRSPs as well, but the cost of capital for doing so is much higher because of the tax deductability.

I won't try to convince you to see it through my eyes (i.e. my personal circumstances) and perhaps it is more common to see the scenarios you have painted. However, in some ways you paint a bleak picture that is sometimes contradictory. For example, you do allow that one could effectively receive the maximum RRSP benefit via:

- payroll deduction
- seeking a reduction in tax at source
- borrowing to invest in the RRSP the amount that would be refunded

Yet, you imply this as not very likely. On the other hand, you argue for the ability to leverage your non-RRSP investments. Well, if a person isn't willing to take any of the above 3 no risk steps for their RRSP's, how likely would it be that this same person borrows to invest in non-registered investments?

I have never margined or borrowed to invest (not yet, anyway) but I've taken all 3 of the above steps with RRSP's. I suggest that anyone looking for a professional's point of view (with all due respect to pitz) look at
http://www.talbotstevens.com/pdf/03JL%20-%20When%20RRSPs%20dont%20reign%20supreme.pdf Talbot Stevens puts forth the argument that pitz is making (there are many articles and strategies on his site but I'll admit I've read very few). His figures show that even if the contributions are taxed at the same rate as the withdrawals, grossing up your RRSP contributions easily outpaces investing outside of an RRSP (this is for the higher income retirees where GIS was never going to be part of their retirement income). I think his article is the type of balanced presentation that is most beneficial to someone trying to understand the options.

The majority of Canadians may not be doing the best that they can for themselves with respect to their retirement planning. If they follow the correct steps, they have a better chance to be successful and sleep well at night if they choose RRSPs. In other words, it is not out of reach for anyone. Of course, it is obvious that if you follow the wrong strategy you will be worse off.

If you want to offer that with a certain amount of leverage you can even counter that, then fine. If you want to state that for people in the lower tax brackets that RRSPs are not a bad thing, they just are not the best thing, then I would certainly agree.

I've been fortunate to be employed at companies that more than match contributions to RRSPs at work. My current employer has a structure where the most favourable (to the employee) scenario is to put in 2%, and then the company kicks in another 5%. I would argue that, no matter who you are, you don't pass up free money! That means that there ARE some reasons to invest in RRSP's after all.

[pitz]

Yet, you imply this as not very likely. On the other hand, you argue for the ability to leverage your non-RRSP investments. Well, if a person isn't willing to take any of the above 3 no risk steps for their RRSP's, how likely would it be that this same person borrows to invest in non-registered investments?


Leverage is a fact of life for nearly everyone, rich or poor, at some stage in their lives. When the RRSP owner wants to pick up a new car (or house), they have to finance using non-deductible debt. When the non-RRSP owner wants to buy something, they (rationally) liquidate their highest cost base investments, make the purchase, and then repurchase the investments using borrowed money.

The difference is that unsecured financing traditionally is a lot more expensive than secured financing (legislation makes it pretty much impossible to use RRSPs as security, since they survive bankruptcy in many provinces). And the deductible interest scenario further lowers the cost of capital, to the point where borrowing money is almost 'free' (after inflation).

I would personally suggest that this discrepancy means an absolutely huge difference over the entire lifecycle of a modern Canadian. How much extra money would be in your pocket if you paid 35% less mortgage interest on your $300k mortgage after 25 years? (my calculation in Excel says $125,000) Or what about your car loan?


I have never margined or borrowed to invest (not yet, anyway) but I've taken all 3 of the above steps with RRSP's. I suggest that anyone looking for a professional's point of view (with all due respect to pitz) look at


But you do have a mortgage, right? How can you claim that you have not borrowed to invest then?


http://www.talbotstevens.com/pdf/03JL%20-%20When%20RRSPs%20dont%20reign%20supreme.pdf Talbot Stevens puts forth the argument that pitz is making (there are many articles and strategies on his site but I'll admit I've read very few). His figures show that even if the contributions are taxed at the same rate as the withdrawals, grossing up your RRSP contributions easily outpaces investing outside of an RRSP (this is for the higher income retirees where GIS was never going to be part of their retirement income). I think his article is the type of balanced presentation that is most beneficial to someone trying to understand the options.


Its a bit out of date (the benefits of RRSPs have been eroded recently with changes to the dividend tax rates and personal income tax rates), but the idea is generally the same.


If you want to offer that with a certain amount of leverage you can even counter that, then fine. If you want to state that for people in the lower tax brackets that RRSPs are not a bad thing, they just are not the best thing, then I would certainly agree.


Sure, investors in the long run are generally better off then spenders. If a RRSP, and its tax provisions helps a person psychologically feel that they are accelerating the accumulation of long-term wealth, that, in itself, is reason enough to be encouraged. Being allowed to leverage the government's money, and to do so in a tax-deferred environment allows investors to take certain risks that they ordinarily wouldn't take, and to hopefully be able to dynamically re-allocate capital to sectors in need of capital has its advantages as well for investors and the economy as a whole. It can be a double edged sword, to wit: many RRSP investors, in the late 90s, dumped their long-term holdings of bank stocks, consumer stocks, etc., and piled into high tech. And we all know how that turned out. (conversely, taxes can be a psychological restraint).


I've been fortunate to be employed at companies that more than match contributions to RRSPs at work. My current employer has a structure where the most favourable (to the employee) scenario is to put in 2%, and then the company kicks in another 5%. I would argue that, no matter who you are, you don't pass up free money! That means that there ARE some reasons to invest in RRSP's after all.

Sure, but what about some of your coworkers who are perhaps struggling with credit card debt, who could more efficiently use the 2% towards paying down 20%/year debts instead? Your employer is imposing a 'one-size-fits all' solution upon everyone, even though, for some employees, such a solution may be sub-optimal and actually destroying value in the long run.

[don242]

Just a quick running of some numbers comparing paying off your mortgage first before saving or doing both at the same time.

The assumptions are a fixed rate (used the 10 year rate) for the mortgage, $1000 per month of excess cash to either invest or pay off mortgage. Investment rate a conservative 7%.

Scenario A

$200,000 mortgage at 5.6%
Monthly mortgage payment = $1232.45
Monthly contribution to investment = $1000

Result:

After 25 years, your mortgage is paid off and your investments are worth $814,797.

Scenario B

$200,000 mortgage at 5.6%
Monthly mortgage payment = $1232.45 + $1000 = $2232.45
Monthly contribution to investment = $0 initially

After mortgage is paid off in 116 months (~9.5 years), the full monthly payment of $2232.45 is invested.

Result:

After 25 years, your mortgage is paid off and your investments are worth $737,543.


Based on this calculation it makes more sense to begin investing as early as possible while making minimum payments on your mortgage.

Ok, so now what am I missing guys?

[pitz]

Based on this calculation it makes more sense to begin investing as early as possible while making minimum payments on your mortgage.

Ok, so now what am I missing guys?

You are missing a further optimization.

If you have a mortgage, your incremental cost of capital is the mortgage rate in after-tax dollars. For instance, 7%, or whatever your mortgage rate is.

You can lower your incremental cost of capital for investing while maintaining the same overall level of balance sheet leverage by doing the Smith Manouevre or similar. In other words, lowering your incremental cost of capital by your marginal tax rate.

The profitability of an investment portfolio is obviously determined by the spread between one's cost of capital, and one's return on investment.

So the recommendation remains similar -- deal with the mortgage principal ASAP. And then use borrowed cash to invest in a tax-efficient portfolio.

[don242]

You are missing a further optimization.

If you have a mortgage, your incremental cost of capital is the mortgage rate in after-tax dollars. For instance, 7%, or whatever your mortgage rate is.

You can lower your incremental cost of capital for investing while maintaining the same overall level of balance sheet leverage by doing the Smith Manouevre or similar. In other words, lowering your incremental cost of capital by your marginal tax rate.

The profitability of an investment portfolio is obviously determined by the spread between one's cost of capital, and one's return on investment.

So the recommendation remains similar -- deal with the mortgage principal ASAP. And then use borrowed cash to invest in a tax-efficient portfolio.

Ok, I agree. I think I was trying to keep it simple since most will not look at attempting the smith manouvre or something like that. Generally most will just choose between paying off the mortgage or investing in their RRSP. In which case you are better off investing in the choice with the highest interest rate as soon as possible (in this case the RRSP).

But I definately agree that if you are willing to go beyond the basic choice, you are better off using the borrowed cash to invest.

[cannon_fodder]

But you do have a mortgage, right? How can you claim that you have not borrowed to invest then?

Haha, that's an easy one. I don't consider my house as an investment. I don't sell it when it's value drops 10% (like I would a stock), or liquidate it in order to buy a car (as you stated when people have non-registered investments). Has it helped my net worth grow? Yep. But, if I was single, I would not own a condo/house. I would rent a basic apartment and invest the difference (as I did when I was single).

From what you've posted, I sense that you look at the equity built up in the house as a means to an end - in other words, it allows you access to capital for investment. Correct me if I'm wrong, but you see the access to that equity as more important than the appreciation of the house itself.

Frankly, I don't want my house value to go up until I'm ready to sell. If the value of the house goes up too quickly, my property taxes go up and there is no value to me if that happens.


It can be a double edged sword, to wit: many RRSP investors, in the late 90s, dumped their long-term holdings of bank stocks, consumer stocks, etc., and piled into high tech. And we all know how that turned out. (conversely, taxes can be a psychological restraint).
I would be shocked if this applied to only RRSP investors. I would bet there were quite a few non-RRSP investors that suffered through the collapse. So why only focus on RRSP investment yet again?



Sure, but what about some of your coworkers who are perhaps struggling with credit card debt, who could more efficiently use the 2% towards paying down 20%/year debts instead? Your employer is imposing a 'one-size-fits all' solution upon everyone, even though, for some employees, such a solution may be sub-optimal and actually destroying value in the long run.
It is optional - my employer gives you 3% no questions asked. They then match dollar for dollar up to 2% of your contributions.

I see time and time again where you bring up the worst case scenarios to make your point. Yes, I agree that if someone is buried under credit card debt, then that 2% contribution would be better served elsewhere. Of course, that really has nothing to do with RRSP's being a good/bad investment strategy.

I don't think that RRSP's or non-registered investments are a panacea. I don't think they are mutually exclusive. RRSP's have never broken my heart, run over my dog, or left with my wife. I'm better off with them than without them if for no other reason than the incentives provided by the government have greatly encouraged me to save for my retirement. Without RRSP's maybe the best I could have hoped for would have been to be paying down my mortgage as fast as possible, which is not a bad thing.

Perhaps you see RRSP's as one of the steps on the road to being a 'sophisticated investor'. Or, maybe you see it as a detour on that road. It is probably easier for a lot of people to 'graduate' from an RRSP investor to a non-registered investor. Some can make it to the 'big leagues' right away, but for some of us, we need to get comfortable with time in the minors (RRSP's).

[xinasguy]

I heard a few co-workers talking the other day and one was telling the others you cannot take all your RRSP out when you're over 65. She went on to give examples from her parents and their friends. Someone decided to check and called their financial advisor from a bank. They confirmed you are only able to take a portion out but not the whole thing. Is there any truth to this or am I freaking out for nothing? How's that "portion" calculated if it's true? Help! :confused:

[pitz]

I heard a few co-workers talking the other day and one was telling the others you cannot take all your RRSP out when you're over 65. She went on to give examples from her parents and their friends. Someone decided to check and called their financial advisor from a bank. They confirmed you are only able to take a portion out but not the whole thing. Is there any truth to this or am I freaking out for nothing? How's that "portion" calculated if it's true? Help! :confused:

Certain types of RRSPs, particularly ones that are the result of employer sponsored plans, or commuted defined benefit pensions, are subject to locking-in provisions under the Income Tax Act. The goal behind this is to ensure that pensioners maintain a sustainable withdrawal rate and theoretically don't run out of money.

Its not uncommon for pensioners to have difficulty managing their money in retirement, especially if they are in a self-directed RRSP. People who, for 20-30 years of their lives, were often broke and living paycheque-to-paycheque, suddenly are forced to manage their finances. Some are up to the job, but some , if allowed, would just take the money and spend it in an unsustainable manner.

Given the number of retirees or people entering retirement who think they are safe if they 'only spend the interest, never touch the principal', this is very appropriate. If you are 'invested' in a bank GIC, if you spend the interest and do not re-invest, you will suffer a reduction in purchasing power over time due to inflation. All of the dumb senior citizens who are crying like babies over the fair taxation of income trusts are proof of the very poor ability of Canadian seniors to manage their finaces.

[don242]

Quick question about the 'Matrix Mortgage' or the Manulife mortages, do you have to transfer your existing mortgage over to it to take advantage of them? For example if my current mortgage is at TD or something, do I have to transfer it to Firstline to use the matrix mortgage?

I plan on looking into all of this but just wondering about this as I begin to dig into this more.

[fsmontenegro]

Quick question about the 'Matrix Mortgage' or the Manulife mortages, do you have to transfer your existing mortgage over to it to take advantage of them? For example if my current mortgage is at TD or something, do I have to transfer it to Firstline to use the matrix mortgage?

I plan on looking into all of this but just wondering about this as I begin to dig into this more.

Not sure about Matrix, but M1 can be done without moving it - they call it "early access" or something like that. In that case, it operates pretty much like a LoC. Their suggestion is that you borrow from that LoC to pay down your original mortgage.

Personally, I took a good look at them and liked what I saw, but ultimately their rate seems steep (prime). I currently have my mortgage at 5.29 for a couple more years and will revisit the issue then...

[pitz]

Quick question about the 'Matrix Mortgage' or the Manulife mortages, do you have to transfer your existing mortgage over to it to take advantage of them? For example if my current mortgage is at TD or something, do I have to transfer it to Firstline to use the matrix mortgage?


You could do that, or you could just have a 2nd priority HELOC tagged on as the 2nd ranking security interest on the property, behind the primary mortgage.

The beauty of the Matrix Mortgage or Manulife One is that it provides an integrated solution and segregated accounting for both the non-deductible principal account, and the deductible investment account, all secured with one charge against your property. The downside, especially with M1, is the high cost.

[manho]

Prop to everyone, and especially pitz. I'm convinced with pitz arguments, even though I did not follow the formula completely.

This entire thread took me at least an hour to digest from OP's first post to this very last one.

And I agree, as well, that since RRSP taxing policy could change any day (just like income funds), there's a risk behind it making it even less attractive.

[pitz]

And I agree, as well, that since RRSP taxing policy could change any day (just like income funds), there's a risk behind it making it even less attractive.

Well I would implore you to look at the assumptions that bely those formulas and arguments:

It is assumed that outside the RRSP, you will select highly tax efficient investments and not GICs/bonds or even traditional actively managed mutual funds.

If you implement a long-term buy and hold strategy, theres no doubt in my mind that you can at least equal the overall long-term tax efficiency of RRSPs outside a RRSP. The problem is that exceptionally few Canadians have tax efficient portfolios, and thus, advice concerning RRSP contributions remains valid.

Each circumstance is unique, btw, and its outright dangerous to extrapolate advice given here, to your own situation, unless you have a very good grasp of things.