Pay Debt vs Start Your TFSA, RESP, or RRSP?

Most early career professionals are torn by competing priorities. Paying debt vs investing is one of the big dilemmas. Some people will decide to eliminate debt, and then sequentially start investing. However, a compromise to do both appeals to many people. That not only stops the waste of mental energy agonizing over the dilemma, but it also helps you to start building good investing habits.

Once you have your debt at a safe level where you can absorb cashflow shocks and sleep at night, then it is reasonable to start your investing journey. A Tax-Free Savings Account (TFSA) is usually a great place to start. An RESP or RRSP could also play roles depending on your circumstances. Learn why and how.

After-Tax Risk/Return of Debt Repayment vs TFSA

Debt repayment has no investment risk. But you’ll need to take risk sometime.

Nothing can beat debt repayment when you adjust for risk. That is because it is a guaranteed after-tax return equal to the interest rate on the loan. For all other investments, there is some degree of risk and it is closely tied to the expected return. There are a wide variety of risks while investing, and even risks to not investing. Almost everyone must take some investment risk to reach their financial goals. The key is to make it a reasonable risk.

Debt repayment is tax-free. So is a TFSA.

debt vs investing

Debt repayment is tax-free. So, a comparable investment would need to return substantially more to achieve the same after-tax return. For example, if you have a top personal marginal tax rate of 54%, you would need a return of 8.7% to end up with the same cash in hand as paying down a loan with 4% interest. There is no risk-free investment that returns 8.7%. So, debt repayment is hard to beat compared to a tax-exposed investment.

A TFSA is also tax-free. While still not risk-free, this means that a TFSA can come the closest to debt repayment in terms of after-tax risk and return. You only need to beat the interest rate to break even. Broad equity markets can be expected to do that, if you invest in them wisely. You cannot eliminate risk, but you can reduce it to a reasonable level by investing for a long timeframe using a diversified low-fee investing strategy. The TFSA has a number of characteristics that make it ideal for this approach.

The TFSA is a Great Bottle for the Secret Sauce

pay off debt vs invest

Many people think that Warren Buffet has the secret sauce for investing outperformance.

He has made wise investment choices consistently over time. Many are boring (but profitable) sauce makers, like Kraft Heinz. There are company factors and skill that contributed to his success.

However, the other ingredients in the sauce are discipline, leverage to magnify gains, and a long timeframe to compound them. That timeframe is critical to make the most of a TFSA and getting started early while still in some debt (leveraged) could make sense.

Investing in your TFSA vs paying off debt is leveraged investing.

Investing while still in debt is logically equivalent to taking out a loan to invest. That is called leveraged investing because it magnifies the potential risk and reward. In the case of investing while in debt, it gives you a longer investing timeframe for compounding returns than if you delayed to pay off the debt first.

There are good mathematical arguments for leveraged investing.

The obvious one is that if your net return (after fees and taxes) exceeds the interest rate, then you pull ahead each year. You make money that you otherwise would not have. In the simulation below, if you eventually sold the investments and repaid the debt, then you would have ~$150K that you otherwise would not have.

debt investing math

The other reason why investing instead of paying down debt may make sense is inflation. Debt is priced in nominal dollars. Only the interest was paid in the above simulation, but the loan shrinks over time in inflation-adjusted dollars. If your wages increase with inflation, then it takes fewer inflation-adjusted dollars (less work/buying power) to pay the debt back over time. Unfortunately, wage growth may not always pace inflation.

Good behavior over a long timeframe is critical.

The problem with the above illustration is that markets don’t smoothly go up over time. They zig and zag along the way. For a leveraged investment plan to work, you must be able to stick to it over a long time period and ignore the short-term ups and downs. Over very long time periods, equity markets are expected to return more than inflation or interest rates. That is part of the risk-reward relationship, and you can see it born out in the long range chart below.

equities vs bonds growth

If you shorten your timeframe by freaking out and selling a good investment at a bad time, then the math doesn’t matter. You’ve turned investing into gambling. One of the best habits you can form as an investor is to ignore the short-term market moves, news, your brother-in-law, and anyone else who says they know what is going to happen next. The 2008/9 financial crisis was major at the time, but it is a small blip on the above long-term chart.

A TFSA has several features that may help us to behave.

There is a big carrot for using a TFSA well, a stick if you are naughty. For most high-income professionals, the TFSA is small compared to the rest of your eventual portfolio. They can easily use their income or other investments instead of withdrawing from it. So, a TFSA could realistically be left to grow until retirement or even passed on as a tax-free inheritance at death. Likely, a very long timeframe and a huge compounded tax-free return.

The TFSA Super-Powers Grow More With Time

Tax-free savings accounts are most powerful when they are used long-term. That is ironic, given the name, and unfortunately many Canadians use their TFSA as a short-term savings accounts. For high-income professionals, we should be able to use a regular high-interest savings account or room on our line of credit for short-term cashflow blips. Then, we can unleash the super-powers of a TFSA by using it as a growth-oriented investment account.

A TFSA’s contribution room grows with it.

Since the TFSA is such an awesome tax-shelter, the Government has been careful to limit its size. A small amount of contribution room is added annually. Room has accrued every year since 2009 or when you turned 18.

The tax-sheltered space of a TFSA also grows as the investments in it grow. If you take money out of your TFSA, that room remains. So, you could contribute that amount (plus the annual increase) in the following calendar year.

pay off debt vs tfsa

You cannot retroactively make up for that lost growth without taking excessive risk. So, the earlier you start growing your TFSA, the better. This is a good reason why the TFSA is where I would start investing. Even before I have fully eliminated debt – to maximize that long-term growth.

Look at the difference that a five year delay in investing 10K in a TFSA makes. You likely have more than 10K of room. So, don’t delay more than you must.

A big TFSA has special powers in retirement or death.

A large TFSA in old age means more tax-free income. It can play an especially important role as part of the larger retirement portfolio that a high-income professional should have. With minimum RRIF withdrawals and maintaining enough dividend outflow to keep a corporation tax-efficient, you could easily be in the Old Age Security claw back income range. That is effectively a 15% absolute tax increase. TFSA withdrawals do not count towards OAS claw backs and can be used strategically to minimize it while meeting your cashflow needs.

Management of retirement income becomes even more important if one partner dies long before the other. A large TFSA can be rolled over to a spouse as successor holder, likely doubling their tax-free cashflow options. If you both die without having emptied your TFSAs, then they make for a tax-free inheritance. Again, the sooner you start a TFSA, the larger it can grow for the above benefits in the distant future.

Build Your TFSA To Build Good Investing Habits

The TFSA limitations may be psychological advantages.

The main limiter of a TFSA is size. That is unfortunate in the long run since a large TFSA is a major gift. Who doesn’t want more tax-free investing? However, early on that may be a psychological advantage. It may not be as overwhelming to learn to DIY invest using the smaller amount of money that a TFSA allows for. Plus, the other investment account types (like an RRSP or corporate investment account) are most advantageous later when your income is higher. It usually takes a few years to get there. It took me 5 to 10 years.

tfsa trading

Since TFSA room is precious, use an long-term evidence-based strategy, like passive indexing. Learn to invest wisely from the start. Do not use a TFSA for trading or highly speculative investing. Not only does that statistically have a high probability of failure, CRA may target that if you do succeed – and make your TFSA fully taxable.

Use the TFSA carrot and CRA stick to help you get off to a more disciplined start as an investor

Spot & avoid the traps that banks set for you. Carry this lesson forward.

The TFSA is commonly promoted by banks as a high-interest savings account or a place to put their fee-laden mutual funds. You can avoid that trap by opening a self-directed TFSA for investing. The difference between retail mutual funds and simple DIY investing using an All-in-One Asset Allocation ETF is about 2%/yr.

Compounded over time, you could dodge a third of your portfolio being eaten by fees. Take this epiphany and apply it to the rest of your investment accounts as you expand your portfolio in the future. Learning this lesson at the beginning of your investing life will yield massive compounded returns later. It will also save on Kleenex for your mutual fund advisor.

A self-directed RESP could be even better.

While investing in your TFSA vs paying down more debt is one aspect of the decision. Another common question is why not use another account instead? I have already mentioned numerous reasons why the TFSA is a great place to start. Everything I have said could also apply to a Registered Education Savings Plan (RESP). Both favor those with lower incomes and the RESP even gets grants.

TFSA & RESP contributions require after-tax money. Just like debt repayment.

Your tax-burden to access money to contribute is likely lower when starting out. Most people have a period of lower income while in training or building their business. That investment of your human capital will hopefully pay off with more income, but it takes time. Later, it will cost you more in upfront tax to get the money to contribute when you are in a higher tax bracket.

A TFSA can still beat a corporation or personal account while in the highest tax bracket. However, it can take about ten years before the initial tax hit is made up for by the tax-sheltering. The time to break-even is shortened if you contribute while in a lower tax bracket. So, if you have to choose where to put limited (but lightly-taxed) dollars while starting out, a TFSA is even better. An RESP comes out ahead even more quickly due to the grants.

RESP returns are boosted by grants.

An RESP is also after-tax, tax-sheltered, and comes with grants. When, or if, kids come along is an extra variable. However, the contribution required to get the maximum grant is only $2500/yr and you may even get extra grants if you have a low household income that year.

So, the RESP is another account with major advantages to starting early in your financial life. Even while in some debt. Also like a TFSA, don’t fall prey to products (group RESPs). Instead, open a self-directed RESP account and invest using low-fee products that will likely give you higher net returns and more flexibility.

An RRSP is best in a high tax bracket.

The reason why I said a TFSA (or RESP) are usually the best accounts to start investing is because it often takes a few years to hit peak income and pay down debt to a safer level. However, if you are close to peak tax, then an RRSP can be the account of choice. You get a tax refund that can be used to fill your TFSA/RESP or further pay off debt.

Current vs Future Income Tax Rate

When you are close to your peak tax bracket, that is when an RRSP is most useful. That is because you can deduct the contribution against your income. In a 54% tax bracket, that means a 54% refund. Awesome. It is less awesome to get a 30% refund now and take the money out in a higher tax bracket in the future. Still, years of tax-sheltered growth in an RRSP makes it hard to lose compared to a taxed account.

If you are in a high tax bracket and still paying debt, using your RRSP can be helpful. You get a tax refund that you can use to pay off debt faster or to charge up your TFSA.

If debt-free & a maxed TFSA, then an RRSP is next.

If you have maxed out your TFSA, tamed your debt, and are not near your peak tax rate, but will blast off soon, then an RRSP may be useful. A resident or early practice physician with very little debt and a high savings rate could fit this bill. They are as rare as pugicorns, but they do exist. Like pugicorns.

You can start contributing to your RRSP now and take the deduction later when your independent practice ramps up and you jump tax brackets. You may have other priorities competing for your dollars, but remember that money in an RRSP can also be used for the home-buyers plan in a few years if you need to. In the meantime, it is tax-sheltered.

General sequence for investing while in debt.

Starting investing using registered accounts while still in debt can make sense due to their tax and behavioral advantages.

Further, when taking out a loan to invest in a registered account, the interest is not deductible as an expense. So, it is best to use those accounts while also working to eliminate your existing debt rather than taking on more debt to contribute to them.

After you have paid your debt off or maxed out your registered accounts, then it is a more complex decision about where to go next. Those with a high income and low cost of living might incorporate to smooth their income and debt elimination. Someone with a lower income or no option to incorporate may be best off eliminating all debt aggressively.

There may also be times when taking on new debt to deliberately invest in a taxable account makes sense. That requires careful thought, planning, and tracking. Those more complex options will be the subject of future posts.


  1. Very useful post, and helpful way to look at the various options for where to direct extra income.

    From a mathematical/numerical optimization – do the recent changes in current interest rates influence how you would prioritize TFSA/RESP contributions vs paying down non-deductible debt (i.e., your final diagram)?

    For example – I’ve got a professional LOC from my training, which is now 6.2% (which was 2.2% one year ago!).

    At the top tax rate in Ontario – paying this down would result in an after-tax rate return of 13.5%.

    Assuming equities return somewhere in the ball-park of 7-10% return (pre-tax), there seems to be a shift in favour of paying non-deductible debt because of the high marginal tax rate and interest rates.

    If the interest is tax deductible, the argument would shift in the opposite direction (i.e., paying down deductible interest gives an after-tax return of 2.9% on the 6.2% interest rate).

    That being said – there are certainly behavioural/psychological advantages to contributions to a tax-advantaged account, and the above calculations differ with lower marginal tax rates.

    1. Hi TK,

      At lower interest rates, it was an easy argument. At current rates, I think a tax-exposed account (corp or personal) easily loses to debt repayment. However, the tax shelters mentioned level that field and make it very close. For the RRSP and RESP, the tax refund (which you could use to pay debt) and grant (guaranteed 20% return upfront) tip the scales in favor of them. For the TFSA, the math works if you have a long time frame (7-10% market return vs 6% debt interest – both after tax), the account is small, and the advantages make it worth it to me. However, I can easily see how someone else may simply want to eliminate debt. I think that the only wrong answer would be investing before the debt is at least down to a level to absorb emergencies and sleep at night.

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