Discover the ins and outs of registered retirement savings plans

Registered Retirement Savings Plans, or RRSPs, are a little like other investment accounts, except for their tax treatment. You only pay taxes on your RRSP investment, and the investment income it earns, when you make withdrawals from your RRSP or when the account is closed.

Interested in in learning more about RRSP accounts? Continue reading.

Tax on interest income and what to hold in your RRSP account

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 RRSP interest rates are low.

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 25%. Capital gains would be taxed at just 29%.

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.

The RRSP meltdown and how it works

When you take money out of your RRSP, you have to pay tax on your withdrawal at the same rate as ordinary income in the year you make the withdrawal. However, under an RRSP meltdown strategy, you would offset the additional tax by taking out an investment loan and making the interest payments from funds you withdraw from your RRSP (the withdrawals must be equal to the interest payment).

Since the interest on the loan is tax deductible, the tax on the RRSP withdrawal is cancelled out. This, in theory, results in zero tax owing on your withdrawal.

You can then use the investment loan to buy dividend-paying stocks, which you would use to provide income during retirement. Dividend-paying stocks also have the advantage of being very tax efficient.

Judging an RRSP meltdown strategy by the numbers

The idea of withdrawing funds from an RRSP tax free has obvious appeal. However, we’ve looked at a number of different RRSP meltdown strategies over the years and, for the most part, we have found that they serve the interests of the brokerage industry more than those of investors. Here’s why:

Say you make a $5,000 withdrawal from your RRSP and want to offset your tax payable using the interest from an investment loan. Supposing a 5% annual interest rate on the investment loan, you would have to borrow $100,000 to invest in dividend-paying stocks to generate a large enough interest deduction to offset the withdrawal.

The fees and commissions that the investor generates when he or she invests the money are an obvious benefit to the investor’s broker. The investor, meanwhile, significantly increases his or her leverage. Moreover, many investors attempt the RRSP meltdown when they’re at or near retirement. In other words, at the worst time to take on additional debt.

Think of it as a double profit

You might think of investment gains in an RRSP as a double profit. Instead of paying up to 50% of your profit to the government in taxes and keeping 50% to work for you, you keep 100% of your profit working for you, until you take it out.

If you lose money in an RRSP, however, you have a double loss. You lose your money, and you lose the opportunity to have that money grow in a tax-deferred environment for years, if not decades, until you take it out.

That’s why successful investors put only their safest investments in RRSPs. If they indulge in penny stocks, stock options or short-term trading, they do so outside their RRSPs. That way, they avoid the double loss. And they can use any losses they do suffer to offset taxable capital gains.

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