Today, there are three kinds of people: the haves, the have-nots, and the have-not-paid- for-what-they-haves.
~ Earl Wilson
RRSPs work best for the haves. The have-nots might be better off starting with TFSAs, and the have-not-paid-for-what-they-haves should pay down debt first. That would pretty much sum up my general view of using RRSPs. I recently did a telephone interview with LuAnn LaSalle of the Canadian Press on the topic, but I’m so much more coherent in writing.
LuAnn was kind enough to print what I said anyway, and the Canadian Press article did a great job of getting people to question the wisdom of contributing to an RRSP every year no matter what. Even David Chilton, author and retirement savings advocate, feels like debt is the biggest problem in personal finance right now. It seems like this is a question that a lot of people are wrestling with so I thought I would try to tackle it in some detail here while RRSPs are still top of mind. Here are some things for you to think about as you decide where to put your hard-earned cash:
RRSPs vs. Debt: Factors to Consider
1. Type of Debt
Are you carrying credit card debt, car loans, a mortgage, or all of the above? Generally, it’s important to pay down the debt bearing the highest interest rate first, so this would usually be your credit card or line of credit. It doesn’t make much sense to contribute to your RRSP if you are paying the high interest rates charged by credit card companies (usually around 19%). If you have a car loan, it may also be worth your while to calculate how much interest you would save by making a larger payment on your loan. Check your loan documents or call your financing company to see if this is an option. If the RRSP tax break you’ll receive is smaller than your interest savings, it probably makes sense to pay down the debt.
Most people will put mortgage debt in a separate category because the interest rate you pay is lower, and a home is generally considered a good long term investment. I agree with that, but if you have a mortgage, you have debt. If you have debt, it’s costing you money that you could be using somewhere else. It’s worth it to calculate how much interest you will save by paying down your mortgage versus contributing to your RRSP. Another tactic is to contribute to your RRSP and use the refund to pay down your mortgage. Which is the better way to go depends on the math, and many of the other factors listed below.
2. Your Age
If you are in your 20’s, your income level is probably lower than it will be when you reach your 40’s. That means you likely have higher debt levels and less money to contribute to savings. The wisest course of action at this stage is likely to pay down your debt first and try to get your budget to a point where you are living below your means. Once you are making more money than you spend, you can build savings for retirement, buying a home, or any other goal you desire.
If you are closer to retirement, it’s more important to contribute to some type of retirement savings. But if you have credit card debt, it’s still better to pay it off before concentrating on RRSP contributions. If you are older and still carrying a heavy debt load, it’s time to get serious about eliminating that debt for good. It’s the only way to get ahead and start to really plow some serious cash into your retirement savings.
3. Amount of Debt
If you are carrying large credit card balances, you are paying a great deal in interest charges. If you’re in this boat, the first thing to do is plug the hole. Stop spending more than you earn, cut expenses and aggressively pay down your debt. If you keep spending more than you earn, the hole in your boat will get bigger, and we all know what happens next.
If you have a smaller amount of debt, you have more room to decide where to put your savings. You can always decide to put a little in your RRSP, a little toward paying down debt, and use your tax refund to pay down the debt further. Again, your decision will depend on how the math looks for your individual situation.
4. Income Level
If you are in a higher tax bracket, the tax deduction from the RRSP contribution will help you a lot more than someone in a lower bracket. But if you are in a higher tax bracket and you are carrying debt, you need to ask yourself why you would want to pay interest charges. Why let that interest compound against you rather than putting that money into savings where it can compound for you?
If you earn less than $40000 or so, the tax benefits of contributing to an RRSP aren’t as great. It’s probably better for those in this situation to pay down debt first. Once you are in a position to save, you can consider TFSAs or RRSPs, but you may want to contribute to TFSAs first. I recently threw my 2 cents in on the TFSA vs. RRSP debate if you’re interested in more information.
5. Economic Climate
I think it’s really important to have a general idea of what’s happening in the economy at the moment and to have some ideas about what factors might affect it positively or negatively in the future. I recently outlined some reasons to be cautious right now, and I hope to keep readers up to date on these periodically. These things really can affect your personal financial decisions.
If we are in a period of lower interest rates (which may be poised to go higher) and volatile stock returns, you’ll want to factor that into your decision-making process. If you want to avoid stock market risk, you’ll need to resign yourself to lower returns for now. If you want to shoot for higher returns, you’ll need to consider investing in stocks. But be aware that losing your money is a serious risk, especially in the current environment.
Two Schools of Thought
There are a couple of different schools of thought out there on this question of whether it’s better to save for retirement, pay down debt, or do both at the same time. Many financial services professionals will tell you that you should always max out your RRSP contribution to the best of your ability. Personal finance guru David Bach advocates setting aside some money for savings even as you pay down your debt, with the idea that if you don’t get started now, you may never do it. I can see some merit in that argument, but I can also see the benefits of focusing on one financial goal at a time.
Many of us feel overwhelmed with the messages we receive from sources like financial professionals, books, and bloggers like myself. We’re supposed to pay down debt, and save for an emergency fund, retirement and our kids’ education all at once. For most of us, especially when we’re younger, there just isn’t enough money to go around. We can become discouraged and give up when it looks like our goals are unattainable.
As noted in a book excerpt recently published in the Globe and Mail, David Trahair, author of Enough Bull, advocates paying down all debt before you even start to save for retirement. Once you have accomplished that, you will likely be a little older, and hopefully, earning a higher income. At that point, you can put all of your savings into RRSPs and receive a greater tax break since you may be in a higher tax bracket.
I know that this view might be considered extreme, but it could in fact be a very effective strategy for those who have the discipline to achieve debt freedom relatively early. To achieve the maximum benefit from this strategy, you would also need to be very disciplined about saving for retirement rather than inflating your lifestyle once your debt was fully retired.
It can be very empowering to focus on one priority at a time. When I wrote about Your Financial Hierarchy of Needs, the point was to cover the basics first. Spend less than you earn. Develop a budget. Save for an emergency fund. Pay down debt. Save for retirement. Achieve financial freedom. Do it in that order, and don’t try to skip steps. Focus is your friend.
What are your thoughts on this topic? If you have a specific question, I’d be happy to help. Just send me an email or ask about it in the comments section below.