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Remember: Pay yourself first

RRSPs or debt? !

A lot of Canadians ask themselves this question at this time of year - coming off the expensive holiday season, and heading toward the deadline for making registered retirement savings plan contributions for the previous tax year.

They face a tug of war between wanting to pay down debt, whether it's the mortgage or the car loan or the credit cards, and wanting to put some money toward retirement and qualify for a tax break in the process.

The experts have differing views on whether debt payments or RRSP contributions should take priority and, as with most investment decisions, it can depend on your personality and your financial goals.

But independent financial adviser Adrian Mastracci says that either one is a smart choice. "One of the pillars of financial planning is to pay yourself first," says Mr. Mastracci, president of Vancouver-based KCM Wealth Management Inc. "Either way [RRSP contributions and debt repayments], you're paying yourself first." Looking strictly at the returns you can expect from an RRSP investment versus the costs you will incur carrying your debt, the RRSP looks like the better choice - even if the interest rates on your debt outstrip the rates of return on the RRSP investment.

For example, if you face a large credit card bill, most standard bank credit cards carry an annual interest rate on the outstanding balance of 18.5 per cent, considerably higher than the 8-per-cent historical long-term annual returns on the average balanced mutual fund (a mix of stocks and bonds). But the contributions you make to your RRSP are tax deductible, so you'll benefit from a lower tax bill.

You could crunch the numbers yourself to figure out the direct costs and benefits in your particular situation, but there are people out there who have done the hard work for you. For example, www.moneysense.ca has a calculator on its website that allows investors to plug in their own numbers and determine what their debt is costing them, versus the tax savings of an RRSP contribution.

Let's say your gross annual income is $60,000, and you've run up a $5,000 debt on your standard bank credit card.

Your yearly interest costs on that $5,000 balance would be $925. If you invested $5,000 in an average balanced fund under your RRSP, which have historically generated average long-term returns of about 8 per cent, you could expect a one-year return of about $400. That's the long-term average; in any given year, there's a risk you could earn considerably less, or even lose money.

Regardless, that $5,000 investment would also generate anywhere from $1,800 to $2,500 in tax savings, depending on the province in which you live. Even if your RRSP investment lost 17 per cent in that year, you'd still come out ahead by making the contribution rather than clearing off the debt, regardless of where you lived.

Based on that arithmetic, it's an easy call: Make the RRSP contribution.

But it's not always as simple as that, Mr. Mastracci says. "The math alone doesn't tell you the whole story."

Experts caution that, as attractive as the tax benefits of RRSPs look, you don't want to let the debt monster out of its cage as a result. If you're facing monthly payments on loans and credit cards that will take you years to clear off, that puts a heavy weight on your financial flexibility and can ultimately hamstring your savings goals.

"People are under a lot of pressure at this time of year to make their RRSP contributions and, meanwhile, you're taking on more and more debt," says Laurie Campbell of the Credit Counselling Service of Toronto. "It just doesn't make sense to me."

Mr. Mastracci argues that paying off debt is itself a form of investment, and one with a pretty solid return.

He notes that to service a non-tax-deductible loan at a relatively benign 5-per-cent interest rate (say, your mortgage), you're actually paying the equivalent of 7.7 per cent once you consider the pretax earnings you'd need to cover those debt costs (based on a 35-per-cent marginal tax rate.) If you paid off the debt, you would be guaranteeing that these costs would disappear - and not just this year, but every year that you no longer carry that debt.

"You essentially have a risk-free investment that pays you 7.7 per cent," Mr. Mastracci argues.

Balanced funds and equity funds might be able to match, or even beat, 8 per cent but they can't guarantee it; your money is exposed to significant risk to achieve those sorts of returns. A risk-free RRSP vehicle, such as a guaranteed investment certificate, promises only 2 or 3 per cent annually.

Mr. Mastracci likes paying down debt because of the financial freedom you can gain down the line by keeping your debts under control. "The more debt you accumulate, the longer time it takes to get the monkey off your back and start saving for your retirement."

Particularly in the case of a mortgage, you can save yourself tens of thousands of dollars in interest payments over the life of the mortgage if you focus on accelerating your payments early on, even if it means forgoing some gains in your retirement savings.

He notes that, because unused space in your annual allowable RRSP contributions can be carried forward indefinitely, you can always catch up on your savings once your big debt is out of the way.

If you can afford it, Mr. Mastracci suggests you try to put some money toward RRSPs and pay down your mortgage. He says you can achieve this by taking the tax refund generated by your RRSP contribution and putting it toward your mortgage.

Of course, for some people, it's not a question of whether to lower debt or make an RRSP contribution. Instead, the question is whether to increase debt in order to pay for an RRSP, through low-interest RRSP loans widely available at Canadian financial institutions.

RRSP loans are generally offered at interest close to the prime lending rate, which currently sits at 4.25 per cent. In addition, payments are typically deferred for four to six months, enough time to get your tax refund before you have to start paying back the money. It's a relatively low-cost way to pay for your RRSPs if you find yourself strapped for cash at the deadline.

"The first argument is the discipline it imposes," says John Bennett, vice-president of financial products and services at AGF Trust, the lending arm of investment management firm AGF Management Ltd. While the best approach to RRSP saving is to put money away throughout the year, an RRSP loan can serve as a form of enforced saving for people who are chronically saving-challenged.

"People always make their [loan] payments, but they're not as disciplined to be saving that money during the year," says Mike Morrow, an independent financial adviser in Thunder Bay, Ont.

There's also a trick you can employ to lower your debt costs via an RRSP loan.

You take out an RRSP loan at 4.25 per cent and, when your tax refund arrives, you apply it to higher-cost debt, such as your credit card. You're now only going to have to pay 4.25 per cent on that portion of your debt, rather than 18.5 per cent - and you've increased your retirement savings.

Still, experts caution that you need to be very disciplined to make sure you use the tax money you save from your RRSP contribution toward paying down debt - either the loan itself or some other debt - rather than spending it.

Otherwise, you're just adding to your debt load, increasing your monthly payments and making future saving more difficult.

"Unless you have a very strong game plan to use your refund to pay down that debt, don't do it," Ms. Campbell says. Advisers say that if you are going to take out an RRSP loan, keep it short term.

They warn that the big "catch-up" RRSP loans that some financial institutions offer are rarely a good idea. These loans, designed to allow investors who haven't contributed much to RRSPs in past years to make up for lost time by making a big lump-sum contribution, can saddle you with a debt for years.

"People who do RRSP loans should only be doing one-year loans or, at the most, two years," Mr. Morrow says.

The experts also caution against rushing out for a loan simply to make sure you get an RRSP contribution in under the deadline. Mr. Bennett says you should first talk to a financial adviser, to make sure a loan makes sense given your situation and financial goals.

"The reactive idea of just walking into the bank branch and buying an over-the-counter RRSP loan may not be in your best interest," he said. "You've got to set some priorities."

dparkinson@globeandmail.ca

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