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Tax-efficient investing inside and outside your RRSP

When it comes to investment accounts, Canadians have two major choices -- to put your money in a registered retirement account, such as an RRSP or an RRIF, or hold it in a nonregistered account.

Because each type of account has its own advantages and disadvantages, it's important to understand that, in most cases, your retirement portfolio should look different than the holdings in your nonregistered account. That's because there are tax advantages to holding certain types of investments in registered accounts.

Unfortunately, many Canadians don't know that, says Jamie Golombek, vice-president of taxation and estate planning at AIM Trimark Investments, in Toronto. "To be honest, I don't think too many people have money on the outside. They're trying to maximize their RRSP."

Tessa Boyce, regional sales manager for BMO Mutual Funds Inc., in Toronto, says "if you are lucky enough to maximize your RRSP and are looking at a nonregistered account, you want to think about having the most tax-effective investments."

The rule of thumb is that equities should be held outside an RRSP, while income-generating investments should be held inside a registered portfolio.

Outside your RRSP
Ideally, investments that have the potential to create capital gains and capital losses -- largely, equities such as individual stocks, investment properties and mutual funds -- should be held in your nonregistered account.

That's because if a stock rises, only 50 percent of the capital gain is taxed, says Ted Rechtshaffen, president and CEO of TriDelta Financial Partners, in Toronto. By the same token, if the stock declines and you sell it, you can claim a capital loss. If that happens inside an RRSP, you can't use those tax benefits, because RRSP investments are not taxable until you take the money out of the account.

Dividends are also subject to favourable tax treatment when held outside an RRSP. They are treated similar to employment income, which means you're taxed according to your marginal rate or based on the total amount of your income. That is usually a higher rate than what you would pay in capital gains taxes.

Inside an RRSP
On the other hand, Golombek says "highly taxable income-based investments should be held inside a registered plan." That includes investments such as Guaranteed Investment Certificates, or GICs, strip coupons and bonds.

It makes sense to hold these types of investments inside your RRSP because earnings from them are taxed similarly to employment income, which means you pay the highest rates, he says. The advantage of placing those investments inside an RRSP is that you don't pay tax on the earnings right away. So, if a GIC produces $1,000 of income, all of that can be reinvested, so you have more of your money working for you over a longer period of time.

What about income trusts? Where should these popular investment vehicles be held? Rechtshaffen and Boyce say it depends. They point out that distribution payments from income trusts have two parts: a return of capital, which is essentially a partial repayment of the amount you invested, and income.

Rechtshaffen says if the distribution payment is largely made up of a return of capital, then it's best held outside an RRSP. If the payment comprises mostly income, on the other hand, then it fits better inside an RRSP or RRIF.

However, experts say that when it comes to deciding on the investment mix inside or outside your RRSP, these are simply guidelines, as each person's scenario will differ depending on her willingness to take on risk and the length of time she has till she needs access to the money.

Think about time frames and asset mix
Interest-bearing investments tend to have lower returns than equities. So, if you have 20 or 30 years until retirement, you would be shortchanging yourself to confine your RRSP investments to income investments. "You don't want to limit growth," says Boyce.

Rechtshaffen adds that "if you have a really long-term time horizon, you should be investing in a reasonably aggressive portfolio. The biggest mistake I see 30-year-olds make is that they have money market funds in their RSP."

He says investors also have to work out "the appropriate asset mix for what they are trying to do. It really depends on the client, their income needs and how they are using the money."

Golombek adds that most Canadians under the age of 50 need to have some growth in their RRSPs, so they shouldn't be devoted entirely to income investments unless they hold sizable nonregistered accounts that give their entire portfolio mix the split they are looking for.

Beware of risk and other objectives
Golombek says if an investment is particularly risky and has the potential to drop to zero in value, it's best held outside your RRSP, so you can take advantage of the capital loss if things go bad.

Rechtshaffen adds that if you have charitable ambitions and want to donate some of your investments to a good cause, "if it's within an RRSP, it's very difficult to do that."

The bottom line, says Boyce, is that "there is no one magic solution." Tax alone shouldn't drive your investing decisions, but your overall objectives should.

Jim Middlemiss is editor of Canadian Lawyer magazine and co-author of Your Guide to Canadian Law. He's a frequent contributor to the National Post and Investment Executive.

-- Posted: Jan. 31, 2007
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