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In a recent column, I discussed three myths about registered retirement savings plans (read it online here). Today, I'll elaborate on Myth No. 3: You should always keep fixed income inside your RRSP.

This is a widely accepted rule of thumb that has important implications for dividend investors. It holds that, because interest is taxed at your marginal rate while dividends and capital gains are taxed at lower rates, you should keep fixed income inside your RRSP and leave stocks outside (assuming you don't have room for both).

But there's a flaw in this argument: It ignores the rate of return.

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When fixed-income yields were much higher, sheltering interest income did indeed make sense. But with interest rates near historic lows – a five-year guaranteed investment certificate currently yields about 2.5 per cent – you're not saving much tax by stuffing interest-paying securities inside your RRSP. In fact, you can save more tax by sheltering your stocks instead (again, assuming you have limited room).

Let's prove it with some numbers.

The calculations

I'd like to thank Camillo Lento, chartered accountant and assistant professor in the faculty of business administration at Lakehead University, who performed the detailed spreadsheet calculations for this column.

The goal was to compare the performance of two hypothetical portfolios over a 20-year period: Portfolio 1 has a GIC inside the RRSP and equities outside; Portfolio 2 has equities inside the RRSP and the GIC outside. Each portfolio starts with $2,000 in pretax assets, split equally between the RRSP and the non-registered account. (Note: For the non-registered account, income tax is deducted from the $1,000 at the start. With the RRSP, tax is paid at the end of the 20-year period when the money is withdrawn.)

To approximate real-life results, we assumed that equities return 8 per cent annually (3 per cent from dividends and 5 per cent from capital gains). We also assumed that the dividend grows at the same rate as the share price, and that all dividends and interest are reinvested annually (after deducting taxes, if applicable). We then varied the GIC's yield to see how the results would be affected.

Finally, to illustrate results for investors in different marginal tax rates, we looked at both a high-income earner (upper table) and a moderate-income earner (lower table), using 2013 Ontario tax rates on interest, dividends and capital gains. We assumed these marginal tax rates were constant throughout.

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The results

Referring to the upper table, if a GIC yields 2.5 per cent, Portfolio 2 (equities inside the RRSP) generates the highest return. It's worth $3,197 after 20 years, compared with just $2,731 for Portfolio 1 (GIC inside the RRSP). Portfolio 2 also wins when the GIC yields 3 per cent, 4 per cent or 5 per cent.

In these cases, you'd be better off doing the opposite of what the rule of thumb recommends. In fact, the GIC would have to yield about 6 per cent for the conventional approach to produce higher returns.

"The conventional wisdom may have held up in the old environment of higher interest rates, but in today's environment of low interest rates the conventional wisdom isn't so wise any more," Mr. Lento said.

Turning to the lower table, for a moderate income earner, holding equities inside the RRSP is also the better choice when GIC yields are low. However, when the GIC yields 4 per cent or higher, it's better to hold the GIC inside the RRSP instead, in keeping with the conventional advice. This is, in part, because dividends are taxed at just 3.77 per cent in Ontario at this income level. So the tax benefit of sheltering dividends is minimal.

Mr. Lento cautions against drawing broad conclusions from the results. "It's very complicated and there are a lot of moving parts. Over a 20-year period tax rates can change and interest rates will change," he said.

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Another key point: This analysis applies to GICs but not necessarily to bonds. Most bonds currently trade at a premium to their par value. For reasons I've discussed previously, a premium bond held in a non-registered account attracts more tax than a GIC of the same yield.

These calculations demonstrate that, contrary to the old rule of thumb, putting dividend stocks inside your RRSP can be the optimal strategy in some cases. Because everyone's situation is different, we recommend you consult a tax professional to determine what's best for you.

   

Port.

1

Port.

2

  

Interest

Div.

Cap’l

Gains

(GIC in

RRSP)

(Equity in

RRSP)

Diff’nce

Optimal

Port.

High Income Earner (over $135,054 up to $509,000)

2.50%

3.00%

5.00%

$2,731

$3,197

$466

2

3.00%

3.00%

5.00%

$2,821

$3,235

$414

2

4.00%

3.00%

5.00%

$3,027

$3,317

$290

2

5.00%

3.00%

5.00%

$3,275

$3,407

$132

2

6.00%

3.00%

5.00%

$3,571

$3,507

-$64

1

Moderate Income Earner (over $39,723 up to $43,561)

 

2.50%

3.00%

5.00%

$4,496

$4,640

$144

2

3.00%

3.00%

5.00%

$4,623

$4,725

$102

2

4.00%

3.00%

5.00%

$4,915

$4,914

-$1

1

5.00%

3.00%

5.00%

$5,266

$5,132

-$134

1

6.00%

3.00%

5.00%

$5,686

$5,383

-$303

1

       

Source: Camillo Lento

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