investor clinic

I have a self-directed registered retirement savings plan and a non-registered trading account. Does it make sense to hold my growth stocks outside of the RRSP (where capital gains will be taxed at just 50 per cent of my marginal rate), rather than inside the RRSP (where they will be taxed at 100 per cent of my marginal rate upon withdrawal)?

Your question is based on a flawed assumption. It is not true that capital gains are taxed at 100 per cent of your marginal rate when you invest in an RRSP. In fact, with RRSPs – assuming a constant marginal tax rate – there is effectively no tax at all on capital gains (or dividends or interest, for that matter).

I’ve tried to bust this myth before, but it’s like playing whack-a-mole. So let’s try again.

Consider a simple example. Two investors – Steve and Judy – both have \$6,000 in cash that they want to invest in Sky High Marijuana Corp. We’ll further assume that both investors have a marginal tax rate of 40 per cent.

Steve thinks the best way to reduce his capital gains tax is to invest outside his RRSP, so he decides to buy \$6,000 of Sky High shares in a non-registered account. The shares promptly triple in value to \$18,000. Steve then sells them, pays tax of \$2,400 (20 per cent of his \$12,000 gain) and gets to keep \$15,600.

Judy, on the other hand, decides to buy Sky High in her RRSP. Question: If Judy uses all \$6,000 of her cash, how much can she invest inside her RRSP? \$6,000? Nope. The correct answer is \$10,000.

How can that be? Well, assuming Judy has the required RRSP room, she could take her \$6,000 in cash, borrow another \$4,000 (or get it from her own savings) and contribute the entire \$10,000 to her RRSP. She would then get a tax refund for \$4,000 (40 per cent of \$10,000) and use it to pay off the loan (or replenish her own savings).

The key thing to understand here is that, at a tax rate of 40 per cent, \$6,000 in a non-registered account is equivalent to \$10,000 in an RRSP. Judy doesn’t actually have more money; she’s simply converted her after-tax dollars (outside the RRSP) into pretax dollars (inside the RRSP).

Now, let’s see how Judy would fare. Her \$10,000 investment inside the RRSP would triple to \$30,000. When she sells her shares and withdraws the \$30,000, she would pay tax of \$12,000 and keep \$18,000 – \$2,400 more than Steve. Notice the difference is equivalent to the amount of capital gains tax Steve paid. (Judy could have achieved the same result by investing her \$6,000 in a tax-free savings account. In both cases she would end up with \$18,000.)

You can do a similar comparison for dividend stocks, real estate investment trusts, bonds or any other investment. As long as you assume a constant marginal tax rate, an RRSP will always produce a higher after-tax return than the same investment in a non-registered account. So, if you have RRSP room – and if you expect to have the same or lower tax rate when you make withdrawals – you should use it for your growth stocks. (As a paper by CIBC’s Jamie Golombek demonstrates [bit.ly/2CUlZ7E], RRSPs can even come out ahead for people who have a higher tax rate in retirement.)

Now, what if you don’t have room in your RRSP (or TFSA) for all of your investments? In that case, you’ll need to choose the investments that you believe will save you the greatest amount of tax. This is a complex decision, because the optimal asset location depends on factors including your marginal tax rate and your investments’ future returns, neither of which may be known in advance.

As a general rule of thumb, I suggest keeping investments with very low expected returns (a high-interest savings account, for example) in a non-registered account while using your registered accounts for higher-yielding fixed-income securities, foreign stocks and Canadian stocks. Because Canadian stocks qualify for the dividend tax credit, they can also be a good choice for a non-registered account. Growth stocks that pay little or no dividends may also be appropriate for a non-registered account – again, as long as you’ve already maxed out your RRSP and TFSA.

In your model Yield Hog Dividend Portfolio , why is the “book value” of your cash negative?

The negative \$2,218.95 figure doesn’t actually represent the book value of the portfolio’s cash. It is simply an accounting entry that is required to reconcile the total book values of the individual stocks with the portfolio’s initial value of \$100,000. Such adjustments are necessary because book values change when I sell a stock, buy a new stock or add to an existing stock.

To take a simple example, imagine the portfolio initially consisted of just one stock purchased for \$100,000. If the stock appreciated to \$110,000 and I sold it and bought a different stock for \$110,000, the book value of the second stock would be \$110,000. The table would then need to show an adjustment of negative \$10,000 to bring the portfolio’s total book value back to \$100,000 – the starting value we use to calculate the portfolio’s return.

E-mail your questions to jheinzl@globeandmail.com.