Managing Your Finances

My Chartered Accountant Robert Gold and his firm Bennett Gold LLP put out a very useful monthly Business Bulletin. From time to time we will offer his findings and wisdom as it applies to your financial management. More can be learned at their website http://www.bennettgold.ca/

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RRSP season is heading into full swing and many Canadians are going through the annual angst trying to decide if it is better to contribute to their Registered Retirement Savings Plan by the February 29 deadline – and get the tax deduction — or apply the money to help pay down their mortgage.

A Few More Tips

Here are a few strategies to consider if you have contribution room left for your 2011 RRSP:
   1. If you received a retiring allowance last year but didn’t use the special RRSP contribution allowance, you have until the February deadline to make it to your own RRSP but not to a spousal plan. This special contribution does not affect your normal contribution room. But the word special does have significant meaning. You lose it unless you use it by the deadline.
   2. You can make an in-kind contribution, claiming as a 2011 deduction the fair market value of the security at the time of transfer. The in-kind transfer amounts to a disposition that can generate a capital gain or loss.
   A gain is taxable, but you won’t have to pay the tax until you file your return next year. Meantime, you get the deduction on your 2011 return. If there is a loss on the transfer, you cannot claim it. However, you can sell the security for cash that you contribute to your RRSP and report the loss on your tax return.
   3. Consider contributing as much as possible to your RRSP as early in the year as you can to get the most from compounding. Consult with your accountant about estimating your maximum contribution, as you aren’t likely to have all the information needed to calculate the amount this early in the year.
   The 2011 RRSP contribution dollar limit is $22,970. The tax deduction is limited to 18 per cent of 2011 earned income up to the contribution maximum, minus your pension adjustment. Remaining contribution room after your 2011 contributions may also be considered.

The dilemma is particularly vexing these days. The ratio of household debt to disposable annual income is at an all-time high of 153 per cent and Bank of Canada Governor Mark Carney has said he expects it to increase. So it may be no surprise that a recently published poll showed that paying down debt is the top financial priority among Canadians. Managing day-to-day spending and retirement planning took second and third place, respectively.

However, age played a major role in those results. The survey, conducted for CIBC, found that debt repayment was a particular priority for respondents between the ages of 25 and 44, who tend to have more debt and less money to save.

But as we get older, priorities change and it becomes more important to work toward ensuring a comfortable retirement. Respondents between the ages of 45 and 64 put retirement planning at the top of their list.

When it comes to debt, it is often a mortgage that is our largest burden. And unlike our neighbors in the United States, we cannot take a tax deduction for mortgage interest. Thus the rush here to pay down mortgages as quickly as possible. On its face, that plan seems to make financial sense.

For example, on a 6.5 per cent, $100,000 mortgage amortized over 30 years you’re going to pay approximately $126,000 in interest. That makes it tempting to pay down the debt and forsake the RRSP — at least for a while. And, of course, every year you are in debt, real cash is being drained from your savings account.

On the other hand, regular contributions to your RRSP provide tax-deferred compounding and a tax deduction that gets you a refund. Of course that refund helps create a future tax liability because when you retire you will have to pay tax on the withdrawals of your contributions and the money they earned while in the RRSP.

Nevertheless, you can still take advantage of the refund now by putting it in an account where it will compound tax free. That could be either your RRSP or a Tax-Free Savings Account, where you could keep it as a reserve to help pay those later taxes. The refund can also be applied to your mortgage.

When it comes to your mortgage, do the math and consider these three options:

1. Pay off your mortgage and then start contributing to your RRSP. In this scenario, paying off the mortgage provides a guaranteed tax-free return but you will forgo years of tax-free compounding within your RRSP. At the current low mortgage rates, the RRSP returns will more than likely beat out your mortgage rate. This option is particularly attractive to individuals in lower tax brackets.

2. Maximize your RRSP while paying your mortgage regularly. If your goal is to retire debt free, this may be the best choice when you have more years left on your mortgage than you have before you plan to retire. This strategy requires you to be in a high tax bracket.

3. Apply your refund to your mortgage and maximize your RRSP. This is potentially the best of both worlds.

But there or other possibilities: If paying down your mortgage quickly is a priority, consider bi-weekly payments. You will make 26 payments rather than 12. As a result, you’ll make one additional payment each year that is applied to the principal of the loan. You save thousands of dollars in interest costs and shorten your amortization period.

To calculate the benefits, divide your monthly payment by two and multiply it by 26 (or divide the monthly payments by four if you want to make weekly payments, then multiply by 52.) If your monthly mortgage payment is $800, or $9,600 a year, your bimonthly payment would be $400 every two weeks and $10,400 annually. The following chart illustrates how you can save more than $20,000 with bi-weekly payments:

Accelerated Bi-weekly vs. Monthly Payments¹

$100,000 mortgage at 6.5% interest compounded semi-annually

Payment Frequency	Number of Payments	Interest Costs ($)	Principal Payments ($)
Monthly/$670	300 25 years	100,956	100,000
Bi-weekly/$335	538 20 years, 9 months	80,354	100,000
Amount Saved		20,602

Accelerated mortgage payments notwithstanding, there is another way to pay down your mortgage while building up your RRSP.

Consider that same 25-year mortgage with the $670-a-month payment, and let’s assume that you:

Are in a 40 per cent tax bracket;
Have $500 a month left after paying all your budgeted items and putting money aside for emergencies;
Have $5,000 to use as a lump-sum contribution to your RRSP or apply to your mortgage; and
Are trying to decide whether to put the extra money into your RRSP, with 6.5 per cent assumed annual earnings, or apply it to your mortgage.

Using an RRSP vs. mortgage calculator that you can find online, you will discover that the $5,000 lump sum and the extra $550 a month payment would produce these results:

The amount of the mortgage and interest would drop by $79,436.42 and your amortization period would drop to 8.83 years.

Investing in the RRSP would generate the same amount of money over the same period plus tax savings of about $23,200.

Using the tax savings to pay down your mortgage would lower the amount of the home loan with interest by $60,143.12 and your mortgage amortization period would decline to about 14.25 years.

In this specific scenario, you would get the best of both worlds: On top of the after-tax value of your RRSP, you would save in mortgage interest costs and reduce the term of the loan.

The decision between paying down a mortgage and investing in an RRSP is very personal and should be made with the help of your accountant, taking into consideration all of your other financial needs and goals.
¹Source: Mortgage Wise Booklet, Canadian Bankers Association through Bennett Gold Chartered Accountants LLP