Allan and Eileen are a young couple with a large mortgage and two children. They have $1,500 available. Should they pay down their mortgage or put the money in a Registered Education Savings Plan (RESP), Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA)?

“The answer largely depends on the timing of Allan’s and Eileen’s financial goals,” says Bill Hyde, CPA, CA, a Partner with Millard, Rouse & Rosebrugh LLP in Brantford. “In this case, funding the children’s education through an RESP is the priority in terms of timing.”

Bill_Hyde_Millards_Brantford

Bill Hyde – Millards

Investing the money in an RESP also provides the highest net economic benefit, Hyde says. Assuming the couple’s marginal tax rate is 40 per cent, the interest rate on their mortgage is five per cent, and that the marginal tax rate on an RRSP contribution will be the same when the funds are taken out, Hyde calculates that the net economic benefit of a $1,500 contribution to an RESP would be $1,134. This compares to a net economic benefit of $945 from investing the same amount in an RRSP, a TFSA or paying down the mortgage by that amount.

“The federal government provides a Canada Education Savings Grant (CESG) of at least 20 per cent of the RESP contribution,” Hyde says. “This additional amount makes the RESP the best option of the four.”

The down side of an RESP contribution is that it does not trigger a tax reduction. Tax is payable by the student on the accrued earnings of the RESP as the funds are drawn out. However, in most cases, the student is not in a taxable position when this occurs. If the child does not pursue an eligible post-secondary education program, the CESG is returned to the government.

“Contributing to an RESP and paying down the mortgage are a virtual tie in my mind, although I would lean more toward the RESP the older the children are,” says Eugene Cholkan, CPA, CA, a Partner with Cholkan & Stepczuk LLP in Toronto. “Otherwise, I would recommend paying down the mortgage.”

Cholkan says financial security should be Allan’s and Eileen’s top priority. “The last thing they want to do is uproot their young family by selling their home because of financial difficulty,” he explains. “Several things beyond their control could lead to that, such as job loss or an increase in interest rates.”

For example, an increase of two per cent on a $300,000 mortgage would increase a monthly mortgage payment by about $325, Cholkan says. “Paying down the mortgage principal can help Allan and Eileen keep their monthly payment as low as possible, if interest rates are higher when they have to renew. It also creates equity in their home that can help them get a low-cost home equity line of credit to temporarily cover unexpected expenses.”

Choosing between paying down the mortgage and contributing to an RRSP also depends on the difference between the interest rate paid on the mortgage and the rate earned on the investments inside the RRSP. If the rate earned on investments is higher, Allan and Eileen may want to consider the RRSP contribution, says Hyde. “If the marginal tax rate is lower when the funds are withdrawn from the RRSP that when the funds are contributed, there will be a benefit to contributing to the RRSP,” he adds. “Even if the tax rate is not materially lower at that time, the longer the funds are invested, the greater the benefit of contributing to an RRSP.”

Hyde and Cholkan both say that putting the money in a TFSA is the least attractive option for Allan and Eileen.

“TFSAs should be used when the RRSP limit has been fully funded and mortgage debt has been eliminated,” advises Hyde.

Cholkan agrees that the time is not right for the couple to contribute to a TFSA, “Except, perhaps, if they are temporarily saving up for a renovation or for a new car. Even then, with the meager interest available these days, it hardly seems worthwhile going through the motions and using up TFSA room.”