A Taxing Dilemma: What Goes Inside Your RRSP?
12/15/2010 11:05 am EST
Conventional wisdom on Registered Retirement Savings Plans (RRSPs) isn’t always correct, says John Heinzl, reporter and columnist for Globeinvestor.com.
Some rules you just don't question: brush after every meal; don't cross on a red light; and keep bonds and GICs inside your RRSP and leave your dividend-paying stocks outside.
You've probably heard the rationale. Interest is fully taxed in a non-registered account, whereas stocks benefit from the dividend tax credit and from a preferential tax rate on capital gains. So if you have limited RRSP room, you're better off sheltering your fixed-income securities, and leaving stocks in a non-registered account to take advantage of the tax breaks.
Or so the conventional wisdom says. But today, we’re going to show why the conventional wisdom isn’t always correct, particularly in an era of rock-bottom interest rates.
Investor Clinic is indebted to Camillo Lento, a lecturer in accounting at Lakehead University, who contacted us with the idea for this column and shared some sophisticated spreadsheet calculations.
If you think about it, when interest rates are extremely low, you’re not getting much tax savings by keeping bonds or GICs inside an RRSP. That’s because you aren’t earning much interest to shelter in the first place.
So it only makes sense that, with dividend yields these days often substantially higher than interest rates on fixed-income securities, it might be preferable in some cases to put dividend stocks inside the RRSP, not outside.
It’s important to remember that we’re talking here about a scenario where an investor has a limited amount of RRSP room and has to decide which investment—fixed-income or a dividend stock—should go inside the RRSP to generate the maximum after-tax return for the overall portfolio.
We also want to stress that the following calculations are complex, that they rest on certain assumptions and that every person’s tax situation is different. So don’t make portfolio allocation decisions based solely on what you read here. Our goal is merely to illustrate that the conventional wisdom, which appears to have originated in an era of much higher interest rates, doesn’t always apply.
Consider an Ontario investor who is in the 43.4% tax bracket, both now and in the future. This investor has pre-tax income of $2,000 to save for retirement, and plans to put half the money into a dividend stock and the other half into a GIC. (Note: The RRSP will have an initial value of $1,000 because tax is deferred until the money is withdrawn. The non-registered investment will have an initial value of $565.90, because tax of 43.4% is deducted upfront.) The investor can put the dividend-paying stock or the GIC inside the RRSP, but not both. She wants to know which allocation will maximize the after-tax return for her overall portfolio. We’ll assume:
- The stock has a dividend yield of 4%.
- The stock price and the dividend both grow at 5% annually.
- All dividends and interest compound annually, tax-free inside the RRSP and on after-tax basis outside.
- After 20 years the RRSP is collapsed and all taxes paid.
You may have noticed that we haven’t yet specified an interest rate on the GIC. That’s because we’ll be holding all of the other variables constant, then changing the interest rate to see how it affects the outcome. We want to determine the minimum interest rate that’s required to justify the conventional advice of putting the GIC inside the RRSP. We’ll call this the “break-even” interest rate.
If we assume an interest rate of 3% on the GIC, there is no contest: Leaving the GIC outside the RRSP and putting the stock inside is the superior choice. As you can see from the table, by following this strategy the investor would end up with $3,963.97 after 20 years—$534.43 more than if she had put the GIC inside. So, doing the opposite of what the rule of thumb recommends is indeed the preferable strategy here.
The same is true for interest rates of 4%, 5% and 6%. Putting the stock inside the RRSP wins in each case. As the interest rate rises, however, you can see that the advantage of putting the stock inside diminishes. This is what you would expect, because the higher the interest rate, the more benefit there is to sheltering the interest income instead.
According to Mr. Lento’s calculations, only when the interest rate hits about 6.25%, or more, is it preferable to put the GIC inside the RRSP and leave the stock outside. If you’ve looked at GIC rates recently, you’ll know that five-year GICs are paying less than half of that. Of course, interest rates—and the other variables—can change a lot over 20 years.
One Size Doesn’t Fit All
Remember, the results in the table here apply only to the specific marginal tax rate, province, dividend yield and growth rate used in the example. If we had changed these variables, the “break-even” interest rate would also have changed. For instance, if the stock had a lower yield, the “break-even” interest rate would also be lower. Similarly, the “break-even” interest rate is lower for investors in lower tax brackets.
“The main take-home message is that the conventional wisdom is not a general rule that should be applied blindly. Retirement planning is much more complicated than something a general rule can capture,” Mr. Lento says. “So I think it’s important to do your own analysis or hire someone to do it, because depending on your situation, the rule may not lead to your optimal asset allocation.”
In or out?
Interest rate and the net benefit (cost) of “stocks-inside RRSP” strategy: