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29 Ways: Day 22

Dividend fans: RRSPs are your friend, not your enemy Add to ...

In my Investor Clinic video last week ( ), I argued that putting dividend stocks inside a registered retirement savings plan is a perfectly acceptable strategy for some people. Because there are no taxes on capital gains or dividends in an RRSP, the investor benefits from tax-free compounding.

Well, some readers took issue with my thesis. Keeping stocks inside an RRSP is actually a lousy idea, they said, because the investor “loses” the dividend tax credit (DTC) and the preferential tax rate on capital gains. Income isn’t taxed inside the RRSP, but once the money is withdrawn, the investor pays tax at his or her full marginal rate on all the dividends and capital gains, which is why it’s supposedly better to leave stocks outside the RRSP to take advantage of the tax breaks.

Today I’m going to show you the flaw in this argument. The notion that RRSP investors pay more tax is actually an illusion. The truth is that with RRSPs there is no tax on dividends, capital gains or interest. That’s precisely what makes RRSPs (and tax-free savings accounts) so attractive.

I can see some of you shaking your heads, so let’s look at an example. Now, it’s true that some investors may have a higher tax rate in retirement, and for these people RRSPs may do more harm than good. For our purposes, however, we’ll assume the investor has the same effective tax rate now and in the future. (If you have a lower tax rate in retirement, the argument in favour of RRSPs is even stronger.)

Okay, imagine you’re in a 40-per-cent tax bracket and you contribute $1,000 of pretax dollars to an RRSP. Normally, if you earned $1,000, you’d have to pay tax of $400. But because you’re contributing to an RRSP, you get to defer that $400 in tax.

Now assume that your $1,000 contribution grows by 8 per cent annually through a combination of capital gains and dividends, and that you reinvest all of your dividends. At the end of 20 years, your RRSP would be worth $4,660.96. When you withdraw the funds you will pay the taxman his share and you’ll be left with $2,796.58 (60 per cent of $4,660.96). The government will get $1,864.38 (40 per cent of $4,660.96).

Here’s the key question: Where did that tax of $1,864.38 come from? The answer is that it represents the future value of the $400 in tax that you were able to defer initially. That’s all. Remember, this was never really your money. It was the government’s. It’s as if the government is saying “I’d like my money back now, please, plus the growth on my money.”

To prove this point, let’s go back to the example. We’ll assume that you contribute the same $1,000 to the RRSP but this time you divide it into two imaginary piles. The $600 pile is your own capital. The $400 pile is the deferred tax that actually belongs to the government.

At an 8-per-cent growth rate, your $600 pile would grow to $2,796.58 after 20 years. Notice that this is the same as the after-tax amount that you got to keep in the first scenario.

And the government’s $400 pile? It also grows at 8 per cent, and after 20 years it would be worth $1,864.38. This is the same as the tax the government collected in the first scenario.

In other words, when you withdraw money from an RRSP, you’re only paying the government the deferred tax plus the growth of that deferred tax. The rest of the money – your own capital, plus dividends and growth of that capital – is all yours to keep. You aren’t paying a penny of tax on the dividends or capital gains generated by your own capital inside an RRSP.

Now, let’s look at what would happen if you invested outside an RRSP instead. Some people think this is a better way to go because you get the dividend tax credit and a 50-per-cent reduction in tax on capital gains. But as you’ll see, assuming the same tax rate now and in retirement, you would actually be worse off.

The first thing you need to do, because you’re investing outside an RRSP, is deduct the 40-per-cent income tax from your $1,000 in initial capital. So in this case, you’ll start with $600 in after-tax dollars. As in the previous example, we’ll assume that the money grows at 8 per cent annually. (We’ll further assume half of that comes from dividends and the other half from capital gains.)

Now, if there were no tax on dividends or capital gains, you would actually get that 8-per-cent growth, right? But because you’re investing in a non-registered account, you will pay tax on your dividends every year. And when you sell your investments after 20 years, you will also pay capital gains tax. The dividend tax credit and capital gains exemption help, but they don’t eliminate tax. So your total proceeds will clearly be less than the $2,796.58 you netted in the RRSP scenario.

How much less? Assuming your dividends and capital gains are both taxed at 20 per cent, after 20 years your $600 would be worth about $2,210 after-tax – or about $587 less than in the RRSP scenario.

Clearly, holding stocks inside an RRSP is the better option.

The take-home point here is that, outside of an RRSP, the government does tax you on income and capital gains earned on your own money. So you get hit twice – first by the initial tax on your income, and again by taxes on the dividends and growth of your capital. With an RRSP, however, you’re in effect only paying tax on your initial income. The tax hit looks so large because that initial tax bill, which you deferred, has grown for 20 years at the same rate as your investments.

What about tax-free savings accounts, you ask? Assuming the investor’s tax rate doesn’t change, a TFSA will produce the same result as an RRSP. Why? Because, just like an RRSP, there is no tax on dividends, capital gains or interest in a TFSA. The only difference is that you pay your income tax upfront with a TFSA, and you pay it later with an RRSP.

As I mentioned earlier, RRSPs may not be appropriate for everyone. But if you avoid RRSPs in the mistaken belief that they somehow cause dividends and capital gains to be taxed at a higher rate, you’ll end up paying more tax, not less.

Follow on Twitter: @johnheinzl

 

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