Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on successful investing, including tax shelters. Each Investor Toolkit update gives you a fundamental piece of investment strategy, and shows you how you can put it into practice right away.

Tip of the week: “These 3 powerful strategies will help you make the most of your RRSP tax shelters”

Registered Retirement Savings Plans, or RRSPs, are the best-known and most widely used tax shelters in Canada.

RRSP contributions are tax deductible, and taxes are deferred on growth in the value of investments you hold in an RRSP. You only pay taxes on RRSP withdrawals. However, RRSP tax advantages come at a cost. RRSP withdrawals are taxed as ordinary income. In an RRSP, you don’t get any benefit from the lower rate of tax on capital gains (half the rate you pay on ordinary income), and the dividend tax credit doesn’t apply to dividend income you get in an RRSP.

(Note that you can contribute up to 18% of your earned income from the previous year to an RRSP, to a maximum of $22,000). March 1, 2011, is the last day you can contribute to an RRSP and deduct your contribution from your 2010 income.

Here are 3 powerful strategies you can use to make the most of your RRSP tax shelters, both now and in the future:

RRSP Strategy #1: Stick with conservative investments in your RRSP: We advise against holding speculative investments in your RRSP. If you hold higher-risk stocks in an RRSP and they drop, you have an immediate loss in your net worth, but that’s not all. You also miss out on the tax-deduction value that you’d get if the loss occurred outside your RRSP. When you lose money in your taxable account, outside your RRSP, you can use the loss to offset taxable capital gains.

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Moreover, a loss in your RRSP also deprives you of the opportunity for tax-free compounding that the money would have enjoyed within your RRSP tax shelters. That’s particularly costly. After as little as seven years in an RRSP, the ability of an RRSP contribution to grow and compound free of tax may be worth as much as your initial contribution itself. That’s why RRSPs are a bad place for aggressive investments of any kind. The potential damage that these investments can do to the tax shelter value of your RRSP is just too costly.

RRSP Strategy #2: You can use your RRSP to defer mutual-fund taxes: Holding good-quality stocks comes with a built-in tax shelter value. That’s because you only pay capital gains taxes on stock market gains when you sell at a profit. But mutual funds have to buy and sell more often than you do, to raise money for departing investors or to invest cash from new fund buyers. At year end, mutual funds distribute any “net” capital gains (after deducting any capital losses) they have made during the year, to their unitholders.

If you hold your mutual funds outside your RRSP, you’ll have to pay capital gains tax on those capital gains distributions. That’s true even if the fund made the gains before you invested in it. But if you hold your mutual funds in an RRSP, you get to defer taxes on those capital gains until you take the money out of the RRSP.

RRSP Strategy #3: Consider early RRSP withdrawals only in years of little or no income: Making early withdrawals from your RRSP only makes sense in a year of low income, which puts you in a low income-tax bracket, and you have exhausted all other sources of cash. That may happen in years when you are ill, say, or unemployed.

On the other hand, if you have cash to invest during a year of low income, a tax-free savings account (TFSA) is a good place for it. Like an RRSP, a TFSA is a tax shelter. But unlike RRSPs, contributions to a TFSA are not deductible, and withdrawals from TFSAs are not taxable.

Investing in a TFSA in low-income years will provide a real benefit in retirement. When you’re retired, you can exhaust your TFSA first, without paying any tax, and only then begin making taxable RRSP withdrawals.

Next Wednesday, January 12, 2011, Investor Toolkit will give you our investment advice on when you should sell a stock.

You can get our latest “safe-investing” strategies for RRSP investing, as well as clear buy/sell/hold advice on lower-risk investments, in our Canadian Wealth Advisor newsletter. Best of all, you get one month free when you subscribe today. Click here to learn how.