Contribute to Retirement or Pay Down Your Mortgage?

Posted by admin on June 5, 2007 in Investment Advice, Real Estate, Taxes

Its taken me almost 50 posts but I thought I would finally wade into the contribution to retirement (through an RSP, 401K or IRA) or pay down your mortgage. There seems to be an equal proportion of advocates supporting paying down the mortgage as those who support contributing to retirement.

My thoughts on an emotional level are similar to Four Pillars on this matter- do what you feel is most comfortable. However, the real reason why I am writing this post is that the debate has been framed as an “either or” proportion by some- either you contribute to your retirement or pay down your mortgage. There is no other option. Of course, life is simply not like that. Decisions must be made in the context that we live in. Thus, I decided to actually run through some scenarios and see how I would react.

As a starting point, the following tax analysis on this matter is technical true- you should contribute to retirement instead of paying down your mortgage unless the interest on your mortgage is 3 % higher than your return in your retirement portfolio and you will move your regular mortgage contribution to your retirement account once the mortgage is paid off. As a tax lawyer friend of mine said, retirement contributions results in deferred tax whereas paying down your mortgage does not reward you from a tax perspective (in Canada anyway; in the U.S., you get tax relief by deducting interest paid on your mortgage). It rewards you from debt management and cash flow perspectives so it depends on how you frame the argument- again, context is everything.

However, real life tends to overtake tax analysis so here are some typical life scenarios and what I would do. For shorthand, I will use the term “lack of equity” to describe someone with little equity in their home and “significant equity” to describe someone with a lot of equity in their home. My analysis is underlined with certain assumptions so obviously the results change if the assumption do. Please note that this is not the “right” answer- these are merely the decisions I would make.

SCENARIO ONE-lack of equity, small retirement portfolio: Typically, someone in this situation is either quite young or has over-extended their small net worth to buy a home regardless of age (they may have with-drawn under their retirement funds to make a down-payment on their home). In this case, my inclination is to pay down the mortgage- if you are young, debt is a huge obstacle to financial freedom; if you are older and your mortgage is still quite large, it may be within your best interest to build equity into the home (on the assumption you will downsize on retirement and pocket the profit from the sale of your home to live on). I willingly concede that if you are older, contributing to retirement may be an equally strong impluse but paying down debt also frees up more cash for your heirs after death. It really comes down to your life-style, income and excess retirement contribution room so neither paying down the mortgage or contributing to retirement is wrong for me in this situation. Ideally, I would make a small monthly contribution to my retirement and use surplus cash to pay down the mortgage. Verdict: pay down mortgage if younger if older either option works as long as you are committed to it.

SCENARIO TWO-significant equity, small retirement portfolio: Typically, someone in this situation has either used most of their free cash to make a down payment on their home or used most of their free cash to pay down the mortgage. If true, this means that this person most likely has significant contribution room in their retirement and they haven’t deferred too much tax over the years (because they have not contributed to a registered retirement plan, they cannot rely on the tax deduction that results from a contribution). In this case, I would set up a monthly contribution to my retirement portfolio and use all free cash to contribute to retirement; debt appears under control so its time to build up equity for retirement and defer my taxes more aggressively. Verdict: contribute to retirement.

More to come tomorrow.

6 Comments on Contribute to Retirement or Pay Down Your Mortgage?

By FourPillars on June 5, 2007 at 12:27 pm

Thanks for the link – I’ll be expecting my traffic to go through the roof!

One interesting point which I remember reading is that an rrsp can also act as a safety blanket/emergency fund.

For example in your first scenario – if the young couple have a sizable mortgage and no rrsp or savings and one of them loses a job/becomes disabled etc then they might have a tough time keeping the house if they can’t make the payments. On the other hand if they have some rrsps then if the situation is dire enough, then they can withdraw to help them through the bad times. Assuming they are unemployed at that time, the tax hit shouldn’t be too bad. You could make the argument that having a larger mortgage and an “emergency amount” in an rrsp is safer than having a smaller mortgage and no rrsp.

By admin on June 5, 2007 at 3:25 pm

Thanks for the comment. I have never been a huge fan of thinking of a RSP as an emergency fund piggy bank. If you withdraw from your RSP, there is immediate withholding of up to 30% (on over $15,000 withdrawal outside Que.) and the withdrawal amount is taxed as income at year end. You also lose the contribution room forever- taken together, its a pretty onerous penalty.

By Canadian Capitalist on June 5, 2007 at 5:20 pm

I don’t quite understand the part why a mortgage pay down is not rewarding from a tax perspective. If I am in the 40% bracket and make an extra payment on the mortgage, I’ll be earning about 5% after-tax and guaranteed on my investment for the life of the loan.

My personal opinion is either option is a good choice but I am leaning slightly towards the mortgage pay down camp because average investors are posting poor returns by chasing performance (DALBAR study). An RRSP is a good choice only if the portfolio is well thought out, not if the investments are an odd jumble of last year’s winning funds.

I do agree though that a good thumb rule would be keeping the retirement portfolio and home equity as equal as possible.

By admin on June 5, 2007 at 5:33 pm

Thanks for the comment. As for your comment about a guaranteed return on paying down the mortgage, from what I understand about how tax lawyers think (and they are a strange bunch), your analysis is based on inputed return on investment rather than the pure tax analysis of a dollar for dollar deferral of taxes when you contribute to a registered retirement plan. This is why tax lawyers/accountants like Tim Cestnick argue for contributing to retirement. As I wrote in the post, its a pure tax argument without regard to other aspects of the argument.

Part II of this post actually deals with how poor returns on investments may affect one’s choice. You must be a mind-reader.

By FourPillars on June 6, 2007 at 12:22 pm

I don’t think the rrsp should be a emergency fund of first resort. However, I’m thinking that if you are facing a long term unemployment for some reason then the income tax shouldn’t be a huge problem ie it would be like being retired and withdrawing expense money.

As for the withholding taxes on specific withdrawals – all you have to do is keep your withdrawals to $5000 or less and the withholding tax will be 10%. If you need more than $5k then just do subsequent $5k withdrawals each day.

Losing the contribution room is definitely a drawback as well.

Just to be clear – I’m not suggesting that the rrsp should be used as a piggy bank – only that there are potential benefits to having at least some money in your rrsp even if you have a large mortgage. Kind of a homemade insurance policy which hopefully will never get used.

Mike

By Thicken My Wallet » Blog Archive » Contribute to Retirement or Pay Down the Mortgage- an update on June 28, 2007 at 8:04 am

[...] an update on a previous post about contributing to retirement or paying down the mortgage. I am contributing to retirement this [...]