We recently received a question from a reader whose name is Samantha. Samantha asked about the benefits of contributing to a RRSPs (401k for our American readers) for younger investors under the age of 30 who have other debts. My first reaction was – how would I know? It’s been almost a decade since I turned 30, but then I calmed down and looked at her situation and came up with a few suggestions. In addition to my own suggestions I contacted Preet Banerjee of WhereDoesAllMyMoneyGo.com who is much more knowledgeable than myself in these matters, to get his opinion as well. You can think of it like a Pros vs. Joes match! 🙂 A big thanks to Preet for helping out with this one. If you are wondering when the rrsp contribution deadline is then check out my RRSP deadline page.
First let’s take a look at her situation:
Samantha is 25, married with a steady job.
Mortgage – $212,000
OSAP (student loan) = $28,000 at 8% – minimum payment is $309 per month.
Samantha makes $34,500 and her husband makes $49,000.
She has an employee match of 100% for up to 3% of her salary in a group rrsp. Currently her rrsp is about $300 (hey, she’s young!).
Samantha basically asked two questions
- Should she focus more on debt rather than rrsp? Since she is young she has lots of time to contribute to the rrsp later.
- Should she contribute to the rrsp to get the employer match?
The first question is the old “debt vs investment” question which I won’t get too far into since the answer is that in a lot of cases it doesn’t really matter where you put your money since both rrsp and debt reduction are very positive actions. Her student loan does have a higher interest rate (8%) but since student loan interest is tax deductible in Canada, the effective interest rate should not be excessive. It’s possible that the rrsp will outperform the interest rate of the loans but since we can’t predict the future, there is no point in guessing.
A couple of exceptions to the previous statement are:
- If you have excessive debt where the payments are crushing your lifestyle then perhaps the debt repayment should get priority.
- If you have very little savings then you might want to contribute more to an rrsp since it can act as a safety blanket if times get tough.
What Preet said:
At $34,500 her marginal rate is 21.05% in Ontario which means her after-tax interest cost on the student loan is 6.32%. If cash-flow is tight (normally the case at that age), then they could consider shopping for new financing on the loan for less than 6.32% with a similar (or shorter term), or for more flexibility they could even pull that into the mortgage (you’d have to check to see the costs for doing so, namely if you have to pay a top-up premium for CMHC premiums). If the mortgage rate is under 6.32% they would free up a fair bit of cashflow. It is important to note that the debt now becomes longer term, so if considering this you would want to make sure the savings are re-directed into something beneficial (mortgage top-up payments, savings, etc.).
If the husband is not maximizing his RRSP contributions, they would yield an extra 10% for spousal RRSP contribution refunds if he makes them to her spousal RRSP account as his marginal tax rate is 31% versus her 21%.
If they do end up consolidating debts, the extra cashflow (perhaps $150 to $200/month) could additionally be used for further RRSP contributions with the refunds going to accelerating the mortgage (or paying down vehicle loans, credit card balances etc.).
The question of contributing to an rrsp with an employee match is a no brainer – there are very few circumstances where you should not be contributing to an rrsp with an employer match. To do so is leaving money on the table, so if nothing else – contribute enough to get the match.
What Preet said:
I would most certainly take advantage of the matching – that is free money! Don’t even think about it, just do it.
Both Preet and I agree that utilizing the 3% employer match on her rrsp should be a top priority.
After that she can split her extra money on debt repayment and rrsps. The exact proportion will be up to Samantha, but considering that her rrsp is very small, she might consider giving more money to the rrsp at first in order to build up a bit of a safety net. Preet made a great suggestion that the husband should be making the extra rrsp contributions into a spousal rrsp since he is in a higher tax bracket. In other words Samantha should make the 3% contribution to get the employer match and then after that, any contributions will go into the spousal rrsp account.
Preet also came up with the suggestion of consolidating their loans which might free up cash flow to further paydown debt.
Anybody else want to add to this?
Feel free to check out Preet’s personal finance blog.