Paying down your mortgage allows you to reduce your interest costs in the long-run and be mortgage-free sooner. On the other hand, contributing to your RSP or TFSA can help you build your savings for retirement.
An RSP contribution is tax deductible and the amount contributed can grow on a tax-deferred basis. Contributions to a TFSA can grow on a tax-free basis. TFSAs also provide additional flexibility in that amounts can be withdrawn tax-free in one year and put back into the TFSA in a subsequent year.
Factors to Consider
The decision to pay down the mortgage or invest in an RSP or TFSA will depend on each investor’s unique situation and preference. In most cases, the general rule is typically to pay down personal debts first, especially if your investment rate of return is less than the mortgage interest rate. Paying down the mortgage also limits risk by decreasing your debt exposure.
It may be more favourable to contribute to your RSP or TFSA rather than pay down your mortgage in the following situations:
- If your mortgage rate is low;
- If you are able to deduct the interest portion of your mortgage payments, as is commonly the case with rental properties;
- If you are in a high tax bracket, which means your RSP contribution will generate a greater tax benefit than if you were in a lower bracket; or
- If you have a long investment time horizon, since this increases the compounding effects on investment growth inside an RSP and TFSA.
Additional options include contributing to your RSP and using any tax refund to pay down your mortgage, contributing to a TFSA to establish an emergency fund, and splitting your available funds between paying down the mortgage and contributing to your RSP or TFSA. Of course, there is always the option of contributing both your TFSA and RSP, to make the most of these tax-advantaged saving opportunities.
RSP vs. TFSA
Where it may be preferable to contribute to an RSP or TFSA, which one should you choose? The common answer to this question is to contribute to whichever one will generate a higher after-tax income when the funds are withdrawn.
If your current tax rate is higher than your tax rate at the time of withdrawal, then contributing to an RSP will likely produce a higher after-tax income. Conversely, where your tax rate at the time of withdrawal is higher than your current tax rate, contributing to a TFSA will likely produce a higher after-tax income.
If the tax rate is the same, then both strategies will generally produce the same after-tax income. In this scenario, the TFSA strategy may be more advantageous because TFSA income does not affect your eligibility for federal income-tested government benefits such as Old Age Security (OAS) and the Guaranteed Income Supplement (GIS).