We all try to save a few dollars on our loans, mortgage included. That is sensible enough. But many of us overlook the chance to save far larger amounts, thousands of dollars, through tax.
To illustrate, take two friends in an identical situation:
- both are 48 years old;
- each earns $60,000 a year;
- each owns a home, with a $250,000 mortgage payable over 25 years at 3%;
- once every obligatory expense is paid, each has $5,000 of discretionary income a year.
The first, call him Jack, treats personal finance as a private and fairly simple matter. He sees no need for professional advice.
The second, Peter, treats money as complex enough to be worth managing with a professional. He discusses it regularly with his advisor.
Jack’s strategy
For Jack, the best investment is paying off the mortgage as fast as possible. Every year he puts his $5,000 of discretionary income against the mortgage.
Repeating that, he finishes paying for the house in 17 years instead of 25.
Clearing it eight years early and reaching 65 with the house paid off is a good outcome. At first glance it is enough. Still, it is worth looking at what Jack actually holds at 65.
| Assets | Liabilities | Net worth |
|---|---|---|
| His property, at market value | Mortgage debt: $0 | The value of the property |
| Savings: $0 | Savings: $0 |
In retirement, Jack has no mortgage payments left. But the mortgage was never his only expense. Municipal taxes, electricity, groceries, communications, transport, travel and medication all remain.
The flaw in Jack’s plan is liquidity: all of his money is in his house.
Peter’s strategy
On his advisor’s recommendation, Peter approaches it differently. He decides to deal with his retirement income now, because time has an enormous effect on an investment and starting early matters. So he invests $5,000 a year in investment funds.
His income is $60,000, of which roughly $15,000 goes to federal and provincial tax. He therefore puts his $5,000 into a registered retirement savings plan, which entitles him to a tax refund. At his tax rate that refund is about $2,000 a year. That money gets invested too, this time in a tax-free savings account.
Without going into the mathematics of compound interest: with a balanced portfolio returning an average of 5% a year over the same 17 years, Peter will have accumulated roughly $150,000 in his RRSP and $60,000 in his TFSA.
His mortgage balance will be about $100,000. Peter can clear it using the whole TFSA, which is not taxable, plus part of the RRSP, which is.
| Assets | Liabilities | Net worth |
|---|---|---|
| His property, at market value | Mortgage debt: $100,000 | The value of the property |
| Savings: $210,000 across RRSP and TFSA | Savings: $110,000 |
The gap between the two strategies is $110,000. Enough to raise Peter’s retirement income substantially, and to leave him far more financially comfortable than Jack.
What to take from this
Under identical conditions, two different attitudes toward cash flow produce different results.
This example is only an example, and it does not suit everyone. There are situations where the RRSP is best left alone entirely, and others where, used competently, it produces even better numbers.
Every situation is particular, and the solution should be too.
Sergey Levchenko, president of Protecto Assurances, financial security advisor.