Discover types of stocks and other investments to keep outside your RRSP—and the types of investments that benefit from an RRSP tax shelter.

Registered retirement savings plans, or RRSPs, are the best-known and most widely used tax shelter in Canada. The tax treatment of RRSPs is what sets them apart from other investment accounts. Ottawa created RRSP tax shelters to let Canadians invest money on a tax-deferred basis, presumably for retirement.

You can put money in RRSP tax shelters each year (up to a limit based on your income) and deduct it from your taxable income. You only pay income tax on your investment, and the income it earns, when you make withdrawals from your RRSP.

In a way, investment gains in RRSP tax shelters give you a double profit. Instead of paying up to 50% of your investment gains in taxes, you keep 100% of them working for you until you take money out. The RRSP tax deduction allows you to potentially invest more money upfront.

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What to hold in RRSPs

Generally speaking, it’s best to hold interest-bearing investments inside an RRSP. That’s because, of the three forms of income (interest, dividends and capital gains), interest is the highest taxed. Dividend-paying investments, and those expected to yield capital gains, are best held outside. Some investors only invest RRSP funds in interest-paying securities, because they hate to see tax advantages go to waste. However, this makes less sense when interest rates are low, as they are today.

Stocks come with two key tax advantages. The dividend tax credit applies to dividends from Canadian companies, so they are worth around one-third more, after tax, than the same amount of pre-tax income from interest or employment. This advantage goes to waste in an RRSP, but the RRSP tax deduction can still make it worthwhile for some investors.

For example, an investor in the highest tax bracket would pay roughly 54% tax on interest income. Dividend income, after factoring in the dividend tax credit, would be taxed at only around 39%. Capital gains would be taxed at just 27%.

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. This strategy, combined with the RRSP tax deduction, can help maximize your tax benefits.

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.

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.

What returns can I expect from using an RRSP?

Many investors are confident they are taking concrete steps toward a secure retirement. But are those steps based on realistic calculations?

Let’s say you’re 50 and you want to retire at 65. You have $200,000 in your RRSP, and you expect to add $15,000 in each of the next 15 years. To determine if this is enough to retire on, you need to make assumptions about investment returns and income needs. Remember, the RRSP tax deduction can help you contribute more each year.

Long-term studies show that the stock market as a whole generally produces total pre-tax annual returns of 8% to 10%, or around 6% after inflation. For retirement planning, we’ll assume a 6% yearly return, and disregard inflation. Your $200,000 grows to $479,312**, and your yearly $15,000 RRSP contributions add up to $370,088, for total retirement savings of $849,400.

**Be sure to check your math. There are many compound-return calculators available online. For example, you can find a comprehensive compound-return calculator at the Bank of Canada’s web site.

If you continue to earn 6% a year, and you withdraw $50,964 a year (6% of the $849,400 in your RRSP), you can avoid dipping into capital until your mid-70s, when RRIF rules call for steadily rising withdrawals.

However, if you start taking money out faster, or earn lower returns, you’ll run out of money. If you withdraw $90,000 a year while earning 6%, the money you’ve accumulated will last just over 13 years. If you earn 5% but withdraw $90,000 a year, your money will be gone in just over 12 years.

In summary, Registered Retirement Savings Plans (RRSPs) are a popular tax shelter in Canada, offering significant benefits for retirement planning. The key advantage is the RRSP tax deduction, which allows contributors to reduce their taxable income. Investments grow tax-deferred within the RRSP, with taxes only paid upon withdrawal. The article discusses optimal strategies for RRSP investments, suggesting that interest-bearing investments are best held inside RRSPs due to their high tax rates outside the shelter. Conversely, dividend-paying stocks and those expected to yield capital gains are often better held outside RRSPs to take advantage of preferential tax treatment. Mutual funds are recommended for RRSP inclusion, while speculative stocks are advised to be held externally. The article also provides a hypothetical scenario to illustrate potential returns from RRSP investments, emphasizing the importance of realistic calculations and assumptions in retirement planning. Overall, RRSPs offer a powerful tool for Canadians to save for retirement while enjoying immediate tax benefits and long-term growth potential.

Do you have a registered retirement savings plan? If so, what types of stocks are you holding in it? Please share your experience with us in the comments.

This post was originally published in 2009 and is updated frequently.