Which investments are best inside and outside RRSPs

As we stated in an earlier 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.

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.

Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was published on Feb. 1, 2017 and has been republished on the Hub with permission.