Everyone knows they need to save for retirement. But homeowners also have to pay for an increasingly expensive roof over their heads and frankly, that might take priority for those in their 20s and 30s.
If they can’t afford to do both, how should young adults choose between ramping up their monthly mortgage payments and making valuable contributions to a registered retirement savings plan?
We’ve all heard about the importance of saving early to benefit from the magic of compound interest within an RRSP, especially since the investment income is not taxed during the accumulation phase.
But turns out that it may be more tax-efficient to delay RRSP payments and pay off the mortgage early instead. By tax-efficient I mean using the fewest after-tax dollars to accomplish both goals: paying off the mortgage and making yourself retirement-ready.
Let’s consider a simple example. Traci is 35 with a new home and a promising career. She has a $400,000 mortgage but also wants to accumulate about $1-million in an RRSP by the time she is 65. This latter amount reflects 30 years of inflation so it isn’t as much as it seems.
We will assume her marginal tax rate is 30 per cent for the next 10 years, 40 per cent for the 10 years after that and 50 per cent for the final 10 years before she retires. In other words, her pay rises from $75,000 today to $200,000 – in today’s dollars – by retirement.
Traci can choose to pay off the mortgage by the time she is 65 or pay it off earlier. As for RRSP contributions, she can start saving now or wait a few years. Let’s consider two scenarios.
- Save-early scenario: Pay off the mortgage by 65 and contribute a flat 10 per cent of her pay to her RRSP each year.
- Save-later scenario: Pay off the mortgage by 55 but save zero in her RRSP until 54, then save 25.6 per cent until retirement.
For consistency, we’ll assume a 4-per-cent mortgage rate under both scenarios; higher than present-day rates but still very low historically. We will assume an investment return in the RRSP of 5 per cent, net of fees, in both scenarios, and inflation at 2 per cent.
While Traci will achieve both her goals under either scenario, given what we know about compound interest within an RRSP and investment income being sheltered from taxes while accumulating, one would think the save-early scenario is the obvious way to go. The result, then, may come as a surprise.
It turns out the save-later scenario is slightly more tax-efficient, even though it means Traci does not save a cent in her RRSP until the age of 55. To measure tax-efficiency, I took all the after-tax amounts allocated to both the mortgage and to saving and rolled them forward with 4 per cent interest to age 65. The accumulated amount at 65 was 2 per cent less – after rounding – under the save-later scenario. In other words, deferring saving until age 55 turned out to be 2 per cent more efficient.
In Traci’s case, the bigger tax refund she got by waiting until she was in a higher tax bracket more than made up for not saving early. The comparison does depend on the assumptions made for rates and returns, but only slightly. We can basically conclude that, for Traci at least, the two scenarios are more or less equally tax-efficient.
You might think that the save-now scenario is the more prudent option and also the easier one to follow, but even this turns out not to be true. The accompanying chart shows the percentage of income that Traci is allocating to mortgage payments and retirement saving combined. Mortgage payments and saving are calculated after-tax while income is gross.
Under the save-now scenario, she is paying as much as 41 per cent of her gross income in her early working years. Under the save-later scenario, it is always less than 35 per cent.
We can draw a couple of conclusions from this example. The first is the near-equivalence of saving vehicles. It barely matters whether the money saved goes toward paying off your mortgage or into your RRSP account. If things ever went wrong – a job loss, say, or unexpected medical expenses – you’d have to dip into your accumulated wealth, be it your home equity or your retirement savings.
And eventually, enough money has to go toward both goals. Hence, the importance of saving early in an RRSP is overblown in a low-interest-rate environment.
Second, it might seem easier to save a flat 10 per cent every year toward retirement, but the chart shows it isn’t, at least not for someone like Traci whose marginal income tax rate keeps climbing. She will experience less financial strain under the “save-later” scenario and will still reach both of her financial goals – a paid-off home and a comfortable retirement.
Frederick Vettese is former chief actuary of Morneau Shepell and author of Retirement Income for Life.