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Jim Maroney

:: Frequently asked question: Why should I invest in an RRSP?

:: In the same way April Fools Day pushes personal income tax near the top of many minds, the first day of February signals the launch of RRSP season. Four more weeks and it’ll all be history. This week I thought I’d carry on with my list of frequently asked RRSP questions.

Why should I invest in an RRSP? There are basically two key tax benefits to investing in RRSP:

1. The first benefit is usually the primary motivation for buying an RRSP and that’s the income tax saving that results from deducting an RRSP contribution in calculating taxable income. By contributing to an RRSP what you’re really doing is converting after-tax dollars into pre-tax dollars. For example, consider the case of an employee who has a gross paycheque of $1,500. Assuming a tax rate of 33 per cent, this employee will pay $500 of income tax and receive a $1,000 net cheque from his employer on payday. This employee could choose to buy a $1,000 investment with his net cheque or he could decide to contribute his gross pay of $1,500 to an RRSP in which case he will recover the $500 of income tax he previously paid leaving him with a net cost of $1,000. In each case, the net cost of the investment is the same $1,000; the $500 difference between the two scenarios is income tax because one investment was made with after-tax dollars and the other was made with pre-tax dollars. So given a choice of using a $1,000 to buy a $1,000 non-registered investment or a $1,500 registered investment, which one would you choose? A pretty easy decision I’d say. This also explains, by the way, why 100 per cent of funds withdrawn from an RRSP must be included in the calculation of taxable income – if you received the tax back on the funds you contributed to an RRSP then logically you’d expect to pay tax when the funds are withdrawn.

2. The second benefit is the deferral of income tax that would otherwise apply on the income earned by the investment. This isn’t typically the key impetus for RRSP investors despite the fact it should be. Carrying on with the previous example, if we assume the investment rate of return is 10 per cent (I know, in today’s market that’s a pipe dream but it keeps the numbers simple) and an income tax rate of 50 per cent, the investment held outside an RRSP will be worth $1,050 at the end of one year. In contrast, a registered investment of the same $1,000 amount will be worth $1,100 after one year; if the gross income of $1,500 is invested the value will be $1,650. The difference between the non-registered and registered investment returns is our old friend, income tax. And yes, it’s true that I’m not really comparing apples to apples here because income tax will eventually be paid on the registered investment return, but the difference is that using the RRSP option this income tax will be paid somewhere down the road.

So, in summary, by choosing to invest inside an RRSP rather than outside an RRSP, not only will you have more money to invest because of the tax saving generated by the RRSP contribution, the income you earn will not be subject to tax until some later date.

What investment should I buy with my RRSP contribution? I wish I knew but my crystal ball is a little on the foggy side these days. Rather than focus on specific investments let’s take a look at what type of income we should seek out with our RRSP money.

In general there are really only three types of income investors can earn: (1) interest, (2) dividends and (3) capital gains. Each of these sources of income is taxed at a different effective tax rate: interest income is fully taxed and receives no special tax treatment; dividends are paid out of after-tax corporate earnings and if they are paid by a Canadian company they come with a tax credit attached – a tax credit that, in theory, compensates investors for the fact the income has already been taxed once inside the company that paid the dividend; capital gains differ in that they are only 50 per cent taxable – although the theory is long gone, I believe the rationale for not taxing 50 per cent of a capital gain was to ensure that investors weren’t paying tax on inflationary gains.

If we consider only the highest marginal income tax rates in B.C. we’ll find that interest is taxed at roughly 44 per cent, dividends at 32 per cent and capital gains at 22 per cent.

Let’s look at our same $1,000 investment earning a 10 per cent return (i.e., $100 in year one). If this investment return is interest income, $44 of income tax will be paid leaving a net of $56. For dividend income the tax will be $32 for a net of $68 and capital gains will attract $22 of tax providing a net of $78.

Turning back to one of the key benefits of an RRSP – namely, tax deferral – the question becomes, which investment income is best earned inside an RRSP? Since interest income gets nailed with the highest tax there’s your answer. Simply put, it makes most sense to hold high-tax investments inside an RRSP.

In fact, by earning either dividend income or capital gains inside an RRSP, the special tax treatment available to these income sources is completely wasted – inside an RRSP the dividend tax credit accomplishes absolutely nothing and the non-taxable 50 per cent of a capital gains is meaningless.

For investments inside an RRSP there is no distinction between income sources. It doesn’t matter a hoot whether the income is interest, dividends or capital gains – all are fully taxable when withdrawn from a registered plan. In general then interest income is best earned inside an RRSP and dividends and capital gains receive better tax treatment outside an 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

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