Should I use an RRSP or not?
Question: I have just learned that when monies are removed from mutual funds that are in an RRSP they are taxed at the full tax rate, INCLUDING all capital gains. A couple of months ago I sold some global funds and bought The RRSP version (“clone”), and am now wondering if I did The right thing. As far as I can see it The pros of my transaction are:
- A tax break for The year it is invested. If this is reinvested, then there is more money to grow.
- Distributions are reinvested within an RRSP without The owner paying tax until RRSP is cashed in.
- The cons are:
- Once The RRSP is cashed in, The capital gains will be taxed at The regular higher rate, not The lower capital gains tax rate.
- The MER for The clone funds is about .5% higher than The regular version.
Considering The pros and cons, is it really better to have this money in an RRSP? Has The higher taxation rate been factored in by those that are promoting capital gains generating investments in RRSPs?
Gordon Pape answer: All things being equal, you are best advised to hold tax-advantaged securiti (e.g. those that generate dividends and/or capital gains) outside a registered plan and keep interest-bearing securities inside The plan. However, many people don’t have The assets to run two portfolios, which is why they will invest in stocks or equity mutual funds inside an RRSP.
Consider this math. You have $10,000 to invest. You can put it into an equity mutual fund inside an RRSP, or invest The money outside. Your marginal tax rate is 40%. In both cases, The investment doubles in value.
If you invest outside The RRSP, you’ll pay tax on 2/3 of The $10,000 capital gain. You’ll end up with a tax bill of $2,667.
If you invest inside The RRSP, you’ll pay no tax on The capital gain. But you will pay tax on The full $20,000 (original investment plus profit) when it is withdrawn. Tax bill: $8,000. However, you will have received a $4,000 refund when you made your original contribution. That reduces your net tax bill to $4,000.
You still appear to be better off investing outside The RRSP, but there’s one more factor to consider. What did you do with The $4,000 tax refund you received? If you re-invested this money outside The RRSP, using The same assumptions, you would have generated an additional capital gain of $4,000 in your non-registered plan. After tax, you would have been left with $2,933 profit.
So to sum up: Original investment outside The RRSP nets you $17,333 – principal and after-tax profit.
Original investment inside The RRSP, with The refund reinvested, nets you $18,933, after tax, once The money is withdrawn from The plan.
The RRSP is The better route – if you have The self-discipline to reinvest The refund.