Should you use RRSPs to pay down the mortgage?

Q: My husband and I will have good pensions.

He is thinking that we should cash out our RRSPs to pay down our mortgage.

He thinks that we will be taxed the same amount either way. Your thoughts?

—Linda

A: Some people struggle with whether they should invest or pay down debt. I think there are good arguments for debt repayment over investing in some cases.

For one, Linda, I’m not a fan of having a big emergency fund in cash earning 1%, while your mortgage or other debt is at 3% or more. It’s a guaranteed losing proposition. Some people like the safety net of an emergency fund. I’d rather someone have a modest cash balance and a secured line of credit as an additional emergency fund which you hopefully never use.

If you forever have $10,000, $20,000 or more sitting idle in cash, you could be missing out on RRSP, RESP or TFSA contributions or have debt that continues to accrue interest at a higher rate in the meantime.

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RRSPs can be a bit different, Linda. They’re a great tax deferral tool. And the key word is deferral.

I will challenge your husband’s assertion on the pensions causing you to be taxed the same on RRSP withdrawals now versus retirement. Even if you are in a good defined benefit (DB) pension and work for 30 years, you will have at most 60% replacement of your final average earnings with a 2% pension formula. That means your income in retirement will be 40% lower than it is now. Sure, you will have CPP, OAS and RRSP/RRIF income as well, but you don’t have to take CPP or OAS until age 70. And you don’t have to take RRSP/RRIF withdrawals until 72. There is, therefore, a good chance you will be in a lower tax bracket in the early years of retirement and possibly throughout retirement.

Furthermore, if you cash in your RRSPs today, you will have a large amount of taxable RRSP income added to your existing income. In retirement, your withdrawals will likely be small, periodic amounts each year rather than a lump-sum all at once.

For perspective, Linda, if you have a $50,000 income and you live in British Columbia, your tax payable on a $50,000 RRSP withdrawal is about 31%. If you’re earning $75,000 and take a $75,000 RRSP withdrawal in Ontario, you’ll pay incremental tax of 42%. A $100,000 RRSP withdrawal for someone making $100,000 in Nova Scotia would cost you 47% tax.

If instead you left your RRSPs invested and kept plugging away at your mortgage, you might be paying a 3% interest rate on the debt. Even if your RRSPs only earn 3%, if you eventually just take minimum RRIF withdrawals in your 70s, those withdrawals are only 5-6% of the account balance. These withdrawals won’t likely push you into as high a tax bracket as you would be in today with a lump-sum withdrawal.

From experience, I can tell you that most retirees pay lower tax rates in retirement, Linda, particularly with a bit of planning and especially given the high tax rate you’d pay today on a full year of salary plus your RRSP income.

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You may even lose your job at some point; experience a disability; retire early, transfer a commuted value lump-sum payment from your pension into a locked-in RRSP; or decide to defer your pension start date at retirement – all things that could create a year or number of years where your income is significantly lower and strategic RRSP withdrawals could be made at a lower tax rate than today.

And if you can earn a higher rate of return on your RRSPs than your mortgage interest rate over the long run, this helps to reinforce further not taking RRSP withdrawals as a better strategy. A low-cost portfolio with exposure to stocks could help you do this over time.

I have another consideration for you. If you cash in your RRSPs now, you lose that RRSP room forever. You don’t get contribution room back the same way you do with a TFSA withdrawal. Since you’re both in pensions, you probably won’t earn much more RRSP room going forward, since pensions reduce RRSP room by way of your annual “pension adjustment.” If you use RRSP withdrawals to plow through your mortgage, you may be limited in your tax reduction opportunities in the future. You may even find yourself debt-free eventually and starting to build a taxable non-registered investment portfolio without a place to shelter the income and gains from tax.

In summary, I think most people will pay less tax on RRSP withdrawals in retirement than during their working years. I’m all for early RRSP withdrawals before the age of 72, when they make sense. I’m all for debt repayment, when it makes sense. Debt repayment may be a priority, Linda, but it shouldn’t come at the expense of poor tax planning.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.

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About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.