Since your RRSP is a tax-sheltered environment your investments and investment transactions lose their tax identity while they are inside it. In other words, nothing that happens inside your RRSP causes you to pay tax inside your RRSP.
This can be used to your advantage to reduce your overall tax bill if you try to keep your fixed income investments inside your RRSP (and your non-fixed income investments OUTSIDE your RRSP). You probably already know that if you can reduce the tax your investments and investment growth is subject to, you can grow your assets more quickly.
Any interest income you earn on your fixed income investments is taxed in the year the interest is earned by the investment (and not when you actually receive it either!) at your highest marginal tax rate. That means that if you had earned 5% interest on a bond, the 5% in interest you receive this year is taxed at your marginal rate. If your marginal rate was, say 40%, then 40% x 5% interest payment = 2% – which is lost to tax. That leaves you with an after-tax gain of only 3%…
…UNLESS you held that bond in your RRSP account. In that case, the 5% interest payment is not subject to tax while it is inside your RRSP and you could re-invest ALL of it, instead of just a fraction of it.
Let’s look at an example of how this can save you some money!
Suppose we had an investor, Joe, who had a total portfolio of $100,000 split equally into a $50,000 RRSP account and a $50,000 non-registered investment account. Joe knows his overall asset allocation should be 50% Equities and 50% Fixed Income (just as an example). All $100,000 is to be used towards retirement planning and each account is structured to hold an equal proportion of stocks to bonds – so each account has a 50% equity / 50% fixed income split as well.
For the sake of this argument, let’s say that Joe’s stocks are all non-dividend paying stocks and they only generate a capital gain over time. Let’s also assume that his stocks grows at 10% per year and his bonds grow at 5% per year and that Joe is in a fictitious 50% tax bracket.
On an annual basis, his RRSP pays no tax on the investments or the growth. The long term rate of compounding growth on his RRSP is simply a matter of calculating the weighted average growth of each asset class. In this case, 50% weighting to stocks returning 10% (5%) would be added to a 50% weighting to bonds returning 5% (2.5%). This gives us a 7.5% average rate of return for his RRSP account (5% + 2.5%).
His non-registered account requires one more step as we have to calculate the after-tax gain on the investments before calculating the average rate of growth of this portfolio. In this case, the stocks only trigger a taxable event when they are sold, so assuming Joe never sells his stocks (a devout Warren Buffett fan), there is no annual loss to tax. But his bonds pay a 5% return every year and since it is interest income, it is subject to tax every year. Applying his 50% marginal tax rate to the 5% interest payments nets a loss of 2.5% in tax. This means Joe’s bond portfolio averages 2.5% per year in after-tax growth in his non-registered account. Now we calculate the weighted-average growth of the non-registered portfolio as follows: 50% weighting in stocks averaging 10% added to a 50% weighting in bonds averaging 2.5% after-tax. This gives us a 6.125% rate of return on the non-registered portfolio.
When we add the two accounts together – we have a new overall weighted average return of ((50% x 7.5%) + (50% x 6.125%)) = 6.8125% average rate of growth on the $100,000 overall portfolio.
Now, let’s re-arrange Joe’s portfolio so that all his fixed income is in his RRSP account and all his stocks are inside his non-registered investment account. In this case the RRSP’s return is 5% since all the returns are interest from the bonds, but are not subject to tax inside the tax-sheltered account. His non-registered account is all stock, earning 10%. Remember, Joe doesn’t sell his stocks often, so he does not attract capital gains tax on the stocks – hence the non-registered portfolio is growing at 10%.
The new weighted-average return of the overall $100,000 portfolio is now ((50% x 5%) + (50% x 10%)) = 7.5%.
Joe has increased his overall long term rate of growth on his overall portfolio by almost 7/10ths of 1 percent. To give you an idea of how important that small difference is, consider that on a $100,000 portfolio for 25 years it would make for a difference of roughly $18,750!
Remember though that the overall asset allocation is the same as before, but each account will have a distinctly different asset allocation when looked at by itself – and would be expected to have a different risk/return pattern going forward. If your risk tolerance for both original accounts is the same, and the monies have the same time horizon – you would want to consider this strategy.
If, on the other hand, your non-registered portfolio has a different time horizon or risk tolerance than your RRSP – it is not so cut and dried. Most people would access funds before retirement from their non-registered portfolios first and as such may be better off holding more liquid investments (or safer investments) in their non-registered portfolios. Make sure to ask your advisor for some guidance if you are not sure.
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