You may be surprised by the income producing investments that work best with RRSPs

Generally speaking, it’s best to hold income producing investments inside your Registered Retirement Savings Account (RRSP). Of the three main forms of investment income (dividends, interest and capital gains), interest is the highest taxed.

Today, interest rates are low, so in general it doesn’t make sense for investors to hold a lot of fixed-income investments. But if you do invest some of your funds in interest-paying securities, then it’s best to hold them in an RRSP. That way, you don’t let the tax advantages of dividends and capital gains on your other investments outside your RRSP go to waste.

Dividend income producing investments come with two key tax advantages. The dividend tax credit applies to dividends from Canadian companies, so taxpayers who hold Canadian dividend-paying stocks get a tax break.

Investors in the highest tax bracket pay tax of 23% on dividends, compared to about 46.4% on interest income.

Investors in the highest tax bracket pay tax on capital gains at a rate of roughly 25%.

These advantages go to waste in an RRSP and that’s why if you hold both interest-bearing investments and stocks, we don’t recommend holding Canadian dividend companies in your RRSP.

So, if you hold dividend-paying stocks in your RRSP tax shelters, you defer taxes, but lose the dividend tax credit. When you withdraw money from your RRSP, you’ll pay taxes at the same rate as regular income, regardless of how you earned the money. So it’s best to hold dividend-paying stocks outside your RRSP—unless that’s all you hold in your portfolio. If you do, then hold high dividend payers outside and low payers inside.

Finding The Best Income Producing Stocks For Your RRSP

Follow these general guidelines for spotting the best income producing investments for your RRSP so that you keep more for your retirement.

1. Hold speculative stocks outside of RRSPs

   Investments that are more speculative or aggressive are best held outside of RRSP tax shelters. That’s because if you hold them in an RRSP and they drop, you not only lose money on the investment, but you can’t use the losses to offset any capital gains you earn on other investments.

2. Hold mutual funds inside RRSPs

   You don’t realize a taxable capital gain on a stock until you sell it. However, mutual funds make annual capital-gains distributions even if you keep holding your fund units. So it’s better to hold your mutual funds inside your RRSP and keep your stocks outside of it.

3. Look for a reasonable dividend yield
   You can identify income producing investments by their high dividend yields (the percentage you get when you divide a company’s current yearly payment by its share price) or rates of interest they pay. For example, stocks with a dividend yield higher than, say, 3% would typically be attractive to an income-seeking investor.

   However, it’s important to avoid judging a company based solely on its dividend yield. That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a company’s dividend yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield). That can be a sign of an imminent dividend cut.

4. Look for maintained and increased dividends.

   Apart from a high dividend yield, you should look for stocks that have a long history of paying (and raising) their dividends. For a true measure of stability, focus on those companies that have maintained or raised their dividends during the recent recession and stock-market downturn.

   That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

5. Choose investments with a good history of profits.
   It’s always a good idea to invest in companies that have a 5 to 10 year history of profits. Companies that make money regularly are safer than chronic or even occasional money losers. You’ll also want to look mostly for companies that have been paying dividends for at least 5 years—10 years is even better. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying stocks, you’ll avoid most frauds. The last financial measure we like to see in a company is manageable debt. When bad times hit, debt-heavy companies often go broke first.

What types of income producing investments make up your RRSP? Have you had any big winners or losers? Share your experience with us in the comments.