The ‘inside or outside’ asset debate
Once you’ve accumulated some assets, you have to decide where to put them — a decision that’s not as obvious as one might think.
Someone once said that the theories we believe we call facts, and the facts we're uncertain about we call theories.
Knowing this, it's always healthy to review some of the more common investing rubrics floating around — particularly when you're trying to factor in taxes.
Let's say you're a fairly conservative investor with half your money in equities and half in GICs, and have both an RRSP and a taxable brokerage account.
In which account should you place those interesting-earning assets; where should you put the stocks?
The conventional answer has been to put the interest-bearing stuff in the tax-deferred account and the stocks in the taxable account. But, these days, it may actually be the other way around - at least for some people.
At first glance, the conventional wisdom does make some sense. The income you make from GICs is fully taxable at up to 46 per cent in Ontario. As a result, it's clearly more in need of the tax sheltering that RRSPs offer.
In contrast, much of the return from stocks takes the form of capital gains and dividends, which, again assuming the highest tax bracket, are taxed at only roughly 23 per cent (about 29 per cent if you're talking dividend income).
Of course, putting those stocks in your RRSP ensures that these capital gains will eventually be converted into ordinary income, taxed at the highest rate in the future.
Similarly, inside an RRSP, there's no dividend tax credit available, which means dividends effectively become fully taxable once you start making withdrawals.
Despite this, some argue, the greater overall return potential from stocks still tips the scales in favour of sheltering them, not GICs, from immediate tax - particularly in an era of rock-bottom interest rates.
Let's face it, with interest rates so low, you aren't earning that much sheltered income to begin with. This will certainly change, since there's nowhere to go but up when it comes to rates. But that's not going to happen anytime soon.
At the same time, with the dividends on your stocks coming in higher than what you're earning on the fixed-income side, it might be preferable to put such stocks inside the RRSP, not outside, to generate the maximum after-tax return right now.
In fact, with five-year GICs yielding about three per cent, the overall difference between what you're making on the two asset classes is significant.
As interest rates rise, however, the differential is likely to shrink. But, even when the five-year GICs starts earning more, sheltering the stocks will still make sense for awhile.
When's the turning point? I'd say five-year rates would have to be almost twice what they are now, again assuming the highest tax rate. After that, the old rule would likely make sense once again, tilting things in favour of sheltering the interest income.
Of course, that target interest rate would be much different if you were in a lower tax bracket. For Canadians who make less than $40,000 or so, the tax rate on dividends, for instance, is pretty negligible, tilting the equation back towards holding blue-chip stocks outside your RSSP.
It all comes down to how you feel about the future. Do you think stocks will earn comfortably more than GICs between now and when you retire? And what tax bracket do you expect to end up in down the road?
The more stocks outperform fixed income investments, the stronger the case for putting them in the tax shelter. You'd be protecting a fatter return, and that's where the benefit of tax-deferred compounding really adds up.
If your stocks are in a taxable account though, there are other tax strategies to consider. You can, for example, use appreciated gains for charitable donations and selectively cull your portfolio to realize deductible losses while letting your winners ride.
On the other hand, placing the assets with greater appreciation potential in your RRSP allows them to be rolled over to a spouse upon your death, postponing capital gains taxes. This is a key consideration when one spouse is much older than the other or not as healthy.
To complicate things even further, once the contribution limits for TFSAs increase to a meaningful size, you're going to have to include this option in the mix as well.
Every person's tax situation is different, of course. But, as your portfolio grows in size, this "inside or outside" dilemma is definitely something to think about.
At the very least, have your advisor run the numbers based on your personal tax situation and portfolio makeup.
MSN.ca Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.