With the preferred tax treatment of capital gains and dividends, one question that I am often asked is whether it is better to invest inside a tax deferred savings vehicle such as an RRSP or in a non-registered account. However, the treatment of capital gains should not be your only consideration when deciding whether to invest inside or outside an RRSP.
Registered Retirement Savings Plans
RRSPs are a tax deferred savings plan. Funds placed into an RRSP account are deducted from your current income and thus are not subject to tax until withdrawn, normally at retirement. Any investment income earned while the funds remain in the RRSP is not taxed. However, any withdrawals from the account are included with normal income and subject to the full rate of tax in the year of withdrawal.
The benefit of the RRSP is that you can rebalance your account by selling some securities and buying others without triggering capital gains. The tax saved on rebalancing can then be fully reinvested. On the other hand, if funds were held in a non-registered account and sold, there would be a tax bill due on any gains that would eat away at your investment returns over time. Similarly, this potential for an accrued tax liability may discourage some investors from selling off overweighed securities when it may be warranted.
In addition, RRSPs allow you to receive interest and dividends without immediate tax consequences.
If you were to invest your money into equities (common or preferred shares) and subsequently sold the shares at a gain, only 50% of the gain would be included in income for tax purposes. Thus investment in equities is more tax efficient if held outside an RRSP or other tax deferred account.
The assumption of an RRSP is that you will be in a lower tax bracket when the funds are ultimately withdrawn. If however, you expect to be in a higher tax bracket at retirement, taking a deduction now may not make sense. Other considerations:
- If you have a mortgage and the interest rate you pay on the mortgage is consistently higher than the rate of return on your RRSP, you are better to pay down your mortgage instead of contributing to an RRSP. Once you have paid off your mortgage then you can then divert the funds you had used for your mortgage payments to a RRSP.
- If your mortgage rate is less than your investment return in your RRSP, then contribute to your RRSP and use your tax return to pay down your mortgage.
For most Canadians however, it is better to contribute to an RRSP.