Pay down debt, or save for retirement?

Is now the time to get your household debt under control, or does building up a retirement fund take priority?

"It's an age-old debate. It happens every year," says Jeffrey Schwartz, executive director of Consolidated Credit Counseling Services of Canada in Toronto.

But perhaps this is the year that discussion is set to take a new turn. In the third quarter of 2013 the ratio of Canadian household debt to disposable income rose to 163.7 per cent, a new record. Simply put, it means that for every dollar of disposable income we have, we spend $1.63.

This number worries Mr. Schwartz and other debt-watchers here and abroad. Indeed, it has spooked foreign investors who no longer see Canada as a sure bet. The recent plunge in the value of the loonie is one indication of this wariness.

"What am I afraid of? I'm less worried in the short term about interest rates. I'm more worried about a reduction in people's income," says Mr. Schwartz.

At the heart of the problem is risk. As debt levels rise, risk rises, too. Lose your job while paying off $1,000 worth of credit card debt, and that's a pain. Lose your job while trying to pay down $26,000 worth of debt, and that can lead to financial disaster.

"If a lot of Canadians lose that paycheque or it shrinks, then they're not going to be able to service that debt. They won't be able to make that minimum payment each month," he says. "That's where the real trouble starts."

Even so, no one is saying retirement planning is unimportant. With some studies claiming that two-thirds of Canadians aren't saving enough for their golden years, socking away money in a registered retirement savings plan (RRSP) or tax-free savings account (TFSA) seems just as important as debt reduction.

So where should your money go? Here's a list of what financial advisers tend to look at before steering money one way or another.

You might want to make RRSP contributions if:

• You’re in a higher income tax bracket. The RRSP was made for you. Reduce the amount of tax you pay today and owe less tax when you’re in a lower tax bracket upon retirement. (By the way, there’s no debt-payment writeoff at tax time.)
• Your employer matches your contributions or offers a group plan. Yes, this is called free money. If a company offers its employees this benefit, investing in the future is much more tempting. If your portfolio does well, the return on investment grows even larger.
• You are planning to buy a house or go back to school. You can take up to $25,000 out of your RRSP to use as a down payment without having to pay taxes on the funds with the Home Buyers’ Plan. Or withdraw $20,000 to go back to school with the Lifelong Learning Plan. Granted, if you’re swimming in debt already, buying a home is likely not the best move.
• You don’t trust yourself. “Are you addicted to debt?” asks Rhonda Sherwood, a wealth adviser with ScotiaMcLeod in Vancouver. “If you pay down your debt, will you turn your focus to savings – or just rack up more debt?”

It may seem counterintuitive, but paying yourself first, even if it's just $100 a month, might be the better option than throwing all your money and energy into debt repayment. Set up an automatic payment plan with the bank; you can't spend what you can't see.

You might want to pay off debt instead if:

• Your debt is expensive. A high-interest credit card is a balance sheet’s worst enemy – and it can seriously undermine retirement savings, particularly if your RRSPs have hit the doldrums. “If you’re getting low returns on your RRSP and you’re paying high interest rates on your debt, you’re effectively financing your retirement at a very high rate. I can’t put it any simpler than that,” Mr. Schwartz says.
• You can’t stomach the risk. Those living paycheque to paycheque have much more to lose if their investments show lower returns or losses, particularly if they’re entering into their preretirement years and they’ll need the money soon. But that 25-per-cent credit card? Pay it off and you’re getting a rate of return few investments can touch, particularly after taking fees into account.
• You’re in a low income tax bracket this year. Reducing your taxes may sound like a good idea, but if you’re making less money right now, this is not the year to contribute to your RRSP. Your tax savings will be low or even zero. Pay down your debt in 2014 and save that RRSP contribution room for a year when it will do you more good.

So, debt repayment or retirement planning for 2014? Maybe neither, says Stephanie Holmes-Winton, author of Defusing the Debt Bomb, from Dartmouth, N.S. She believes there's one more option that many Canadians overlook at this time of year: an emergency fund. Without one, more people will either go further into debt when life throws a curve ball, or will take money from their RRSP, thus paying expensive withholding taxes and missing out on years of compounding returns.

Even if you're heavily in debt, she recommends setting up an automatic savings plan to build the fund before thinking about retirement planning.

"Everyone needs a cushion before they can start long-term savings," she says.