In the second in our series on RRSPs, an explanation of which investments will help you maximize the tax advantages of your RRSP, and which are better left out.
As we stated in last week’s article on RRSPs (What you need to know to build a productive RRSP) your investments gain doubly in your RRSP. Instead of paying up to 50% of your profit to the government in taxes, you keep 100% of your money working for you.
When you lose, however, you take a double loss. You lose the money you’ve invested as well as the opportunity to have the money grow for years, or even decades, sheltered from taxes.
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So don’t use it as a place to find out if you have a talent for stock trading.
Successful investors put only their safest investments in RRSPs. These investments have the greatest potential to increase in value over time and therefore benefit from the RRSP’s continuing protection from taxes.
If these investors indulge in penny stocks, stock options or short-term trading, they do so outside their RRSPs.
If you hold speculative investments like this in an RRSP and they drop, you lose more than the money you invested in them. You also lose the tax-deduction value of a loss outside your RRSP. Outside your RRSP, you can use capital losses to offset taxable capital gains in the current year, the three previous years, or any future year.
If you invest in mutual funds, you have another set of tax concerns. At the end of the year, mutual funds distribute any capital gains they have made during the year, after deducting any capital losses, to their unitholders. So, you may have to pay capital gains taxes on your mutual-fund holdings, even though you haven’t sold.
If you hold mutual funds outside of your RRSP, you’ll have to pay capital gains tax on half of those realized capital gains. So it’s best to hold these funds inside your RRSP, and common stocks outside.
This is just one of the reasons we prefer index funds to mutual funds, since index funds typically do not make an annual distribution of capital gains (lower fees are an even greater advantage with index funds).
A loss inside your RRSP simply reduces the tax you’ll pay on your last withdrawals from your RRSP savings, perhaps when you reach age 95 and are required to take at least 20% out of your RRIF.
You’ll have less money to take out at that time, so you’ll pay less tax. But this defers the deduction so far into the future as to make it meaningless.
Inside and outside an RRSP—the worst-case scenario
Here’s an example of just how the tax breakdown can work in both scenarios.
Let’s contrast two outcomes for an investor in the 50% tax bracket who invests $10,000 in an RRSP, and $10,000 outside an RRSP.
Here’s the result when the investment is placed within an RRSP. The amount invested earns 10% yearly and rises from $10,000 this year to $45,949 in 2033. After withdrawing the money and paying 50% tax at that time, the investor still has $22,974.50.
Here’s what happens with the same investment outside an RRSP. The investor pays 50% tax to start on his $10,000, and invests the remaining $5,000 at 10% a year. Since he’s paying 50% taxes on the investment income every year, the value of his investment only grows to $10,914 by 2033 — only 47.5% of the after-tax $22,974.50 value of his RRSP investment.
This is a “worst-case scenario”. It only applies to GIC or bond investments. Stocks and mutual funds enjoy some tax shelter outside an RRSP, since tax rates are lower on capital gains and dividends than on GIC interest. But the principle is the same. Your money grows faster if you put it in an RRSP, and pay taxes later rather than now.
Next week: Our advice on how to ensure that you’ve made the right calculations for your retirement income.
Comments
R
Pat, while your RSP vs non-reg comparison has merit in drawing such a stark comparison, I dont think its appropriate comparison for most of your readers, due to the stark fact that investments en masse are complex. You use the worst investment vehicle (which you suggest not to use) of a 10% (?) bond to make an elusive point and forgets the many factors as to invest in what, when, in a persons life.
I suggest doing a ‘over time’ comparison, using real tax brackets during of a persons career and using real investments that you advocate. While your example tries to push for RSP investments vs non-reg, the $50k available in TFSAs dont even make a mention yet are the most prudent vehicle for wealth accumulation. Unfortunately investing is a bit complex, but in my analysis with my very credible CA, RSPs are a 2nd choice, sometime 3rd choice for investments esp as a person who is in their top earning bracket with a decade or so time before retirement, and if they follow your advice, will always be in the top tax bracket. Darn!
Let me make brief example. $10,000 pre-tax during early career is probably $ 8000 after-tax when a 25 year old Investor puts it in TFSA and buys a ‘bank’, growing 10% annually and paying a 4% dividend in a DRIP. Using the Rule of 72, 14% doubles about every 5 years, so from age 25 to age 65, that one time $8000 doubles 8 times, becoming $2 million … all tax free.
Now consider that same $8000 after-tax being invested in the same bank in a std investment account for same period of time … the 10% cap gain growth stays the same, as its not cashed in, however, 4% dividend becomes say 3% after tax, for a total of 13% annualized growth. $8,000 (doubles only 7.3 times) to $1.3 million but is taxed for cap gains at 25%, yielding $770k, and does not have to be cashed in until death, unlike a RIF at age 72.
Consider the same $10,000 pre-tax growing at 14% inside a RSP for same time … $2.6 million, but now faced with a huge 52% tax bill, whenever its pulled out of a RSP , so yielding $1.25 million. And at age 71, it only gets worse and you cant invest in tax shelters anymore. So, why do an RSP anytime you can do a TFSA or give your grandkids a RESP contribution? As a reader, I urge TSI Wealth to do some practical scenarios looking at an entire wealth profile, as to when to do certain types of investments at different investment levels. I think you will find RSPs are yesterdays news due to the fact that most investors will always be in the top tax bracket as they draw down from a long life of good investing following your wisdom. Mutual funds and RSPs are dead …. esp if an investor can use his or her Granny`s or parent`s unused TFSA!
Based on this article , do believe a 34 year old should still take a safety first approach when choosing RRSP investments or is better to be more aggressive?
Thanks for your question. For all investors, Pat still thinks you should stick with his three-part program:
1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight
Pat says that there are a number of difficulties with recommending a model portfolio for all investors. The main one is that each individual has different objectives, acceptable risk levels and so on. For example, conservative or income-seeking investors may want to emphasize utilities and banks for their high and generally secure dividends. More aggressive investors (and that could include the 34-year-old you mentioned) might want to increase their portfolio weightings in resources or manufacturing stocks.
As well, any model portfolio would need to be continually monitored and updated as individual stocks rise and fall in value and as a percentage of the total.
In addition, different investors may be more comfortable holding a larger or smaller number of stocks, REITS or ETFs in their portfolios. So, it’s difficult to set any specific number of stocks in a model portfolio.
However, as mentioned, conservative or income-seeking investors may want to emphasize utilities and Canadian banks for their high, generally secure dividends, but you’ll still want to spread your investments out across the five main economic sectors: Manufacturing & Industry, Resources, Consumer, Finance and Utilities.
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Pat, while your RSP vs non-reg comparison has merit in drawing such a stark comparison, I dont think its appropriate comparison for most of your readers, due to the stark fact that investments en masse are complex. You use the worst investment vehicle (which you suggest not to use) of a 10% (?) bond to make an elusive point and forgets the many factors as to invest in what, when, in a persons life.
I suggest doing a ‘over time’ comparison, using real tax brackets during of a persons career and using real investments that you advocate. While your example tries to push for RSP investments vs non-reg, the $50k available in TFSAs dont even make a mention yet are the most prudent vehicle for wealth accumulation. Unfortunately investing is a bit complex, but in my analysis with my very credible CA, RSPs are a 2nd choice, sometime 3rd choice for investments esp as a person who is in their top earning bracket with a decade or so time before retirement, and if they follow your advice, will always be in the top tax bracket. Darn!
Let me make brief example. $10,000 pre-tax during early career is probably $ 8000 after-tax when a 25 year old Investor puts it in TFSA and buys a ‘bank’, growing 10% annually and paying a 4% dividend in a DRIP. Using the Rule of 72, 14% doubles about every 5 years, so from age 25 to age 65, that one time $8000 doubles 8 times, becoming $2 million … all tax free.
Now consider that same $8000 after-tax being invested in the same bank in a std investment account for same period of time … the 10% cap gain growth stays the same, as its not cashed in, however, 4% dividend becomes say 3% after tax, for a total of 13% annualized growth. $8,000 (doubles only 7.3 times) to $1.3 million but is taxed for cap gains at 25%, yielding $770k, and does not have to be cashed in until death, unlike a RIF at age 72.
Consider the same $10,000 pre-tax growing at 14% inside a RSP for same time … $2.6 million, but now faced with a huge 52% tax bill, whenever its pulled out of a RSP , so yielding $1.25 million. And at age 71, it only gets worse and you cant invest in tax shelters anymore. So, why do an RSP anytime you can do a TFSA or give your grandkids a RESP contribution? As a reader, I urge TSI Wealth to do some practical scenarios looking at an entire wealth profile, as to when to do certain types of investments at different investment levels. I think you will find RSPs are yesterdays news due to the fact that most investors will always be in the top tax bracket as they draw down from a long life of good investing following your wisdom. Mutual funds and RSPs are dead …. esp if an investor can use his or her Granny`s or parent`s unused TFSA!
Thanks for your feedback!
Based on this article , do believe a 34 year old should still take a safety first approach when choosing RRSP investments or is better to be more aggressive?
Thanks for your question. For all investors, Pat still thinks you should stick with his three-part program:
1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight
Pat says that there are a number of difficulties with recommending a model portfolio for all investors. The main one is that each individual has different objectives, acceptable risk levels and so on. For example, conservative or income-seeking investors may want to emphasize utilities and banks for their high and generally secure dividends. More aggressive investors (and that could include the 34-year-old you mentioned) might want to increase their portfolio weightings in resources or manufacturing stocks.
As well, any model portfolio would need to be continually monitored and updated as individual stocks rise and fall in value and as a percentage of the total.
In addition, different investors may be more comfortable holding a larger or smaller number of stocks, REITS or ETFs in their portfolios. So, it’s difficult to set any specific number of stocks in a model portfolio.
However, as mentioned, conservative or income-seeking investors may want to emphasize utilities and Canadian banks for their high, generally secure dividends, but you’ll still want to spread your investments out across the five main economic sectors: Manufacturing & Industry, Resources, Consumer, Finance and Utilities.