An RRSP tax shelter can help you save money when used properly

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

The tax treatment of RRSP tax shelters is what sets them apart from other investment accounts.

Stick with conservative investments in your RRSP tax shelter

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.

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.

Capital-gains strategies for your Canadian RRSP tax shelter

As Canadian capital gains tax is lower than the tax on interest and on dividend income, capital gains is a very tax-advantaged form of income. Here are three strategies for structuring investment portfolios to minimize the tax burden.

1. It is usually best to hold any common shares outside of an RRSP (as dividend income and capital gains taxes are taxed lower than interest income), and interest-paying investments in an RRSP (Unless you only hold stocks, and then it’s okay to hold them in an RRSP).
2. As mentioned above, more speculative investments are best held outside of an RRSP. If investors hold them in an RRSP and they drop, investors not only lose money, but they can’t use the capital losses to offset any taxable gains from other investments.
3. Regarding mutual funds outside an RRSP, the main consideration is that mutual funds make annual capital gains distributions even if investors continue to hold the fund units. Investors then pay Canadian capital gains tax on those realized capital gains. So you are best to hold mutual funds in an RRSP and common stocks outside. You won’t realize capital gains on common stocks until you sell.

What to hold in RRSP tax shelters

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. (Again, unless you only hold stocks, and then it’s okay to hold them in an RRSP)

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.

For example, an investor in the 50% tax bracket would pay 50% tax on interest income. Dividend income, after factoring in the dividend tax credit, would be taxed at only around 29%. Capital gains would be taxed at just 25%.

So, if you hold dividend-paying stocks in your RRSP, 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.

The self-directed RRSP tax shelter

If you have more time to regularly review your investments, you can open a self-directed RRSP, which allows you to hold different types of investments. You can certainly manage the account yourself, but you are not obliged to do so: many investors have a financial advisor handle their self-directed RRSPs. Most self-directed RRSPs have an annual trustee fee, which you pay in addition to trading costs, management fees and other charges. The trustee fee may range from $25 to $250 depending on the size of the account and the financial institution. This fee is typically waived on accounts with a value greater than $25,000.

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.

How have you saved money with your RRSP tax shelter? Share your experience with us in the comments.