TAXFlash News from IncomeTaxCanada.net

Jim Maroney

:: Everyone likes to save income tax and RRSPs fit the bill quite nicely.

:: In my last article I reviewed the importance of income tax in calculating after-tax investment returns. The key point made in my previous article was that the income tax treatment of investment income plays an important role in the investment-making decision. Investors need to understand the effect of income tax in choosing among alternatives.

Generally, capital gains receive the most favourable income tax treatment, followed by dividends and, lastly, interest income. This generalization is true at all income levels except at the lowest personal income tax rate where dividends come in first place and capital gains come in second – at all income levels interest income comes in last place.

Many people invest in RRSPs simply for the “write-off”. Everyone likes to save income tax and RRSPs fit the bill quite nicely. Although often overlooked, the tax-deferred compounding of income earned within an RRSP is of far greater importance than the immediate tax saving realized by the RRSP deduction.

Investment income in an RRSP is not subject to income tax as long as withdrawals are not made from the plan.

Amounts withdrawn from an RRSP are included in the calculation of taxable income and tax is calculated at marginal personal tax rates. All RRSP withdrawals are treated equally – a dollar is a dollar is a dollar – there is no distinction between interest, dividends and capital gains.

Knowing that investment income earned inside an RRSP is not subject to income tax, can investors simply ignore income tax when making their investment decisions where RRSPs are concerned? If income tax doesn’t apply, who really cares what type of investment is held inside an RRSP? Valid questions to be sure.

Remember that interest income receives no special income tax treatment and, for this reason, it makes good sense to hold interest-bearing investments in an RRSP.

On the other hand, dividend income is eligible for a dividend tax credit that works to reduce the effective tax rate applied to this type of investment income. Inside an RRSP, however, the benefit of the dividend tax credit is wasted because income tax does not apply to investment income inside an RRSP. This suggests that dividend bearing investments (e.g., stocks and dividend mutual funds) are best held outside of an RRSP.

Recall that only one-half of a capital gain is taxable – this obviously means that the other half of a capital gain is tax-free. Inside an RRSP this taxable/non-taxable split is irrelevant. In effect, the entire capital gain becomes taxable when earned in an RRSP. So by holding a capital gain bearing investment in an RRSP, an investor is tacitly agreeing to pay income tax on 100% of a capital gain.

And who’s to say an investor will even earn a capital gain? Good point! What if that expected capital gain becomes a capital loss? If the investment is held outside an RRSP, investors can carry capital losses back for application against capital gains realized in the previous three years. If the investor has no capital gains in the three preceding years, the unused capital loss can be carried forward indefinitely for use against future capital gains.

Of course, inside an RRSP the notion of a capital loss is meaningless. If your investment goes in the tank, you simply have less money to withdraw from your RRSP and nothing more. The resulting capital loss is not eligible to be carried back or forward – end of story. As in the case of dividend income, this suggests that capital gain bearing investments are best held outside of an RRSP.

In managing your RRSP your number one objective should be maximizing the return on your investments. If this means holding dividend and/or capital gain bearing investments inside your plan at the expense of foregoing favourable tax treatment then so be it.

True enough, but where you have a choice – say you have registered and non-registered investments – the most tax effective approach is to earn interest income inside your RRSP and dividends and capital gains outside your RRSP.

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Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney
CA Canadian Chartered Accountant with Brown, Andrews & Maroney in Maple Ridge, BC, Canada

Official details about this and other topics on income taxes can be found in English & Francais at www.ccra-adrc.gc.ca
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