Choose Which Is Better

Pay down your debt or increase your savings? As you’ve learned throughout Savings and Debt, there are many considerations, plus a couple more we haven’t addressed yet.

1. Take the “Free Money”

"Free money" could mean that derived by contributing to an RESP to get a CESG or contributing to your employer’s pension or savings plan to get a matching contribution or price discount. Either way, it is to your benefit to take advantage of any such opportunity.

2. Get the highest after-tax return on your money

Compare your debt financing (interest) costs against your investment rate of return. Which one will net you the biggest return after taxes? Use RRSPs when there is a tax advantage. Compare your current and likely future marginal tax rates (MTRs).

An RRSP tax refund today will pay off, if your tax rate when withdrawing the money is lower—the larger the spread, the greater the advantage of using an RRSP. For example, Laria and Angelo each contribute $10,000 into their RRSPs. Compare the tax refund today against the tax paid when the money is withdrawn at retirement.

 

Laria

Angelo

Current tax rate

40%

25%

Tax refund

$4,000.00

$2,500.00

Future tax rate

25%

25%

Tax paid when withdrawn

$2,500.00

$2,500.00

Tax saved

$1,500.00

$0.00


Planning the right strategy depends on your situation. For each of the following circumstances, there is an appropriate plan:

  • High-interest rate debt: Pay off your debt to get an immediate return on your money equivalent to the interest rate you’re paying.
  • RESPs: The 20% CESG your contribution triggers is equivalent to getting an instant 20% return on your money, even before you invest the contribution.
  • RRSPs: The tax refund is extra money you can use today to pay off debt, make another RRSP contribution or put into a TFSA.
  • TFSAs: While you don’t get a tax refund on your contribution, if you’re willing to own at least some equities, the money will grow over time and none of the growth will be taxed, either within the TFSA or when the funds are withdrawn.
  • A home: Your principal residence is a unique investment. If it increases in value, you will not have to pay any capital gains tax on the increase when it’s sold. Investing in home ownership gives you a place to live and a tax-free asset.

Tax Planning Using the Combined Federal-Alberta Tax Table

Which is better? An RRSP or a TFSA? A personal or spousal RRSP? It depends on your marginal tax rate. Find out how. Click the button below to start.

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A Final Word

Paying off debt and saving to achieve future goals: both are good things to do. Your financial stability (that is, your job security, your amount of debt), your assets and the size of your debt payments compared to your income, all play a part in deciding which is better. However, beyond the numbers, you have to be able to sleep at night, comfortable with your decision. Your emotional and your rational sides have to agree on the most appropriate path for you today.

Tomorrow is another day. You may need to change your priorities. That is why it’s important to review your debt-savings decisions annually and whenever a significant change occurs.