Equity Funds - Better Off Outside RRSP?
Some (Gordon Pape, for instance) say ideally equity funds should be held outside an RRSP while inside should be mostly income funds. That's because equity and dividend funds get better tax treatment than income funds. I'm starting to invest outside my RRSP and am wondering if I should go this route. My thinking is I save my valuable tax shelter space for income investments - bond funds, strips, etc. and set up an income account outside for my equity investments - equity funds, etc.
Has anyone considered the long-term implications of this strategy? Are there any good books or links which address this? Thanks in advance for any assistance people might be able to provide.
I should add that I am in a position to invest as much outside my RRSP and inside my RRSP starting in 1998. Thanks again.
It is better to earn capital gains and dividends outside a RRSP because of more favorable taxation rates. To me this is old style thinking.
At the highest marginal taxation rate capital gains amd dividends will still be taxed at about 33% of profits. That is 33% of your profits are not available for reinvestment. If you have been holding corporate or mutual fund shares outside a RRSP this can be a significant loss in your investments. If they were held in a RRSP no such loss would occur until the funds would be needed in retirement. Because of taxation you wouldn't want to realize profits on equity funds, but would want your funds to have a buy and hold strategy for growth. The absolute best reason for RRSPs is that there is a better chance for accumulation of wealth without the imposition of annual income taxes.
Dividend funds are different. They are income funds, purchased to provide income for today, to be spent today. The fact that they may earn capital gains is a bonus, because that is not what they were originally designed to do.
To me the best investments for growth should be inside the RRSP and those required to provide income to be used today, outside the RRSP.
I agree with HP. Conventional wisdom has it that you should keep dividend and capital gain producing investments outside of your RRSP. The reason for this is (as has been indicated) that these investments receive preferential tax treatment. Fixed income investments are the most heavily taxed and thus it is generally advised that they be kept inside your RRSP. However a study by T. Rowe Price indicates something very different. The study pointed out that stocks over time produce greater returns than bonds. Thus the sheltering of those gains resulted in greater end wealth due to the compounding of larger amounts of money (larger because more money was available to compound at higher rates) (this was due to the greater returns generated by the stock funds tax deferred compounding). When you think about it this makes sense. If your bond fund is going to average for example 8% and your stock fund is going to average 12% the tax actually paid on the bond funds earnings would be less in dollar terms than those that would be paid on the stock funds earnings. More importantly (and even if the return differential between stocks and bonds was not as great) the tax sheltered compounding of the equity fund inside the RRSP will produce significantly more money than the bond fund could produce.
Below I have provided the table that summarizes the results of the study. The study assumes a $10,000 investment in each of various fund categories. The initial investment was made on 3/31/76, and a tax rate of 28% (the study is American, and reflects the US tax situation, which is less harsh than our own) was assumed. Liquidation of both accounts occurred on 3/31/96. The bond funds returns are based on Morningstar Inc.'s all-taxable bond fund category.
After Tax Value of Stocks In IRA, Bonds Out and Stocks Out, Bonds In IRA (IRA is the American equivalent to our RRSP).
The study found that the stock in / bond out scenario was valid for all stock categories as long as the portfolio was maintained for at least 10 years.
I came across the study in the October 1996 issue of a magazine called Financial Planing, you may be able to find copies in larger libraries, (I found mine at the Toronto Reference Library). I have only briefly summarized the contents of the article and so would suggest that you try to obtain a copy. If you are unable to do so I will be happy to send you a copy if you will provide me with either your fax number or your address.
Thanks very much for the input, BWG and hp. I will look up the magazine myself. Cheers
So, let's muddy the issue a bit - put the income producing investment (bonds, etc.) into your RRSP, and then put the rest into an "umbrella" structure outside of your RRSP. Or, just buy Berkshire shares.... The point is, there is no one clean answer, it depends on the over-all weights of your portfolio (how much bonds do you want?) and which particular equity assets you're using.
I understand what you're saying. I should revise my asset allocation and then place each fund or bond where it's likely going to do the most good. I don't get the connection with Berkshire shares, but incidentally their track record is attractive. But the 1996 letter warned future growth might be slower didn't it? As I write this, being a two-month "veteran" of FundLib, I bet there's a thread somewhere I missed, right? I'll go check for Berkshire. :) Thanks for the input Rob
BWG, I am very much enjoying this and your other threads. I was just about to start swapping income funds into my RRSP for equities that are outside, so this "debate" is very timely.
I've tried to find the Financial Planning article on the web, but no luck. (The magazine has a website but past articles are not online.)
Could you please e-mail me your e-mail address, and I'll send you my (local call) fax number. Thanks.
BWG - It would be important to know the tax efficiency of the equity investments used for this study. If one held equities or the index for the entire time and the only distributions were dividends, I expect it would be more advantageous to hold the equity portion of a balanced portfolio outside the tax shelter. Dividend rates are typically lower than bond returns so the reinvestment opportunity is lower and the tax on the eventual sale of the portfolio would be lower.
Could this study be an artifact of the belief that managed funds are a good investment?
If all you are able to invest is in your RRSP, you should include the proportion of equities that best fits your circumstances. Otherwise, the point of that rule of thumb is this:
Suppose you have an RRSP account full of equities, and you have a non-RRSP account full of interest bearing investments, and both are part of your long-term portfolio. You should do a switch whereby you keep more equities outside your RRSP, and more of your fixed income inside your RRSP. It is a rule of thumb - to be applied on an individual basis.
Remember, when dealing with investments, tax issues are secondary unless dealing with a special circumstance.
I would caution against doing anything drastic with your RRSP until one is certain about the numbers.
I have some misgivings about some of the arguments given in favour of keeping fixed income outside the tax shelter. The upshot of the argument is that if equities grow at a sufficiently faster rate than fixed income only then will this strategy yield higher overall returns.
I have some misgivings about BWG's table. First, it is uncited. Second, because of the higher income tax rates in Canada, the tables' findings are without meaning. We all know about the power of compounding and how it grows exponnentially over time. A very small differential in the tax rate over a period of 20 yrs can lead to a vastly outcome. Lastly, I don't think IRA'a are equivalent to RRSP's - I'm not entirely certain how they work, but I recall reading somewhere that RRSP's are a better deal for its holders than the US tax shelter.
I'm sure the Canadian financial community would not be recommend this strategy w/o having analysed it sufficiently.
Unconventional Reg here. :)
As U all may know, I am a contrarian at heart. I like to deal in new(er) more novel ideas rather than run with the crowd. Although this article I wrote is not new, it is understood & practiced by few. BTW, Rob is right. There is not a one-fits-all answer. Each situation is different & needs to be looked at on it's own individual merits.
Generally, if someone has interest bearing investments, they should be inside an RSP since they are taxed the most. What I believe most people want is the maximum growth with the least amount of risk. If an RSP is concerned, I'm sure we R into long-term growth. Anything short-term would naturally be outside an RSP. Equities produce superior returns over longer periods of time. So doesn't it make sense to use them inside your RSP as well as outside.
Having an equity fund outside an RSP will produce very little taxation until U redeem it and pay capital gains. Annual distributions usually are a small part of income. Of course the larger the amount in one fund, the higher the annual distribution.
Here is the article I wrote:
ALTERNATIVES TO RRSP INVESTMENTS
The Advocate, Wednesday January 5, 1994
I'm sure most would agree that an RRSP is a good idea. The tax deduction motivates most people to start an RRSP. The higher the marginal tax bracket, the more the motivation - right?
But, is there a better way? How would you like to have the advantages of an RRSP without the disadvantages. Instead of deferring taxes how would you like to eliminate them and still have a tax shelter working for you in addition to making two to five per cent more?
A) $3,600 invested each year in a RRSP for 20 years at 10 per cent = $206,190. To receive a monthly income at this point you have two options: 1) an annuity (fixed monthly income) or 2) a RRIF. Both are taxed as regular income.
If your tax bracket is lower you will pay less tax than you do today. $206,190 would buy a life annuity (guaranteed 10 years) at age 65 of $1,720.02* (fixed monthly income). *Based on November 1993 competitive interest rates.
B) Borrow $36,000 of Other People's Money (OPM) at 10 per cent = $3,600 interest per year. Invest the $36,000 in a Canadian Corporation (Mutual Fund). The interest is now tax deductible. In 20 years at 12 per cent you would have $347,266.55 or $141,076.55 more than A. At 15 per cent (only a few earn this kind of return) it would be $589,195.35 or $383,005.35 more than A.
Less CNIL it would be tax free up to your $100,000 capital gains exemption.(No longer applies) If it was jointly owned you could enjoy $200,00 tax free. For example, you could receive $2,893.89 per month based on a 10 per cent withdrawal program from the $347,266.55 or $3,472.67 monthly based on 12 per cent.
Both significantly more than A. Much of this income comes to you tax free. The monthly amount can also be indexed to inflation to keep up with the cost of living so that you will never get stuck with a fixed income.
Which would you rather be, A or B?
Although RRSP's have helped many Canadians save for their retirement the other side of the coin needs to be examined.
RRSP's are rife with legislated constraints. Here are some of them: 1) 80 per cent plus Canadian contents. 2) Income fully taxable. 3) No collateral value. 4) The income alternatives are carefully prescribed.
With B, a leverage program, you have none of the above restraints. 1) Investments can be globally oriented. This allows them to have a better return because of more and better opportunities. 2) a SWP (Systematic Withdrawal Program) attracts very little tax. 3) excellent collateral value. 4) This is not a government program so the methods of receiving income are not decreed. You have complete control and flexibility.
Should I borrow? If you can invest so that your rate of return is more than your after tax cost, then it makes sense to borrow.
When asked how he made his fortune, the great financier Barnard Baruch replied "OPM- Other People's Money."
We should be careful to define between borrowing for luxuries and consumer goods and borrowing to invest.
NEVER borrow for luxuries. Borrow only to invest.
Disclaimer: This strategy is not for everyone. Consult a professional before attempting to use it.
I don't think there's actually a thread called Berkshire, but it's been discussed on a number of other threads. The reason I threw that in there is that Berkshire has a policy of NOT paying dividends. They pay the taxes within the corporation. That means you'll never have a tax-liability until you actually sell the shares and realize your capital gain. Down-side? Well, at over $40,000 / share, it can get a little expensive to buy Berkshire shares!!
I agree completely. Maybe we can get one of our spreadsheet nuts here to do up a Canadian version of this table and see what happens.
As others mentioned, and I was implying with my "Berkshire' comment - it ALL depends on what the tax efficiency of your equity investments is.
Too bad they took that $100K away, eh?
Rob, re "Well, at over $40,000 / share, it can get a little expensive to buy Berkshire shares!!"
That's why there are now class B (baby?) shares. Each represents 1/30th of a full share at a somewhat more "affordable" price of $US1,500 or so, each :-)
What do people out there think of the Clean Environment Funds. I am considering to invest in them for my kids RSP.
Nice concept, too bad the performance doesn't match up.
Actually I did provide the name of the article and the name and date of the mag. from which it came. The table is from the article in the above mentioned mag. but I shall tell you what it says at the bottom of the table, "Source: T. Rowe Price Associates". If you would like to receive a copy let me know your fax # and I will be happy to send you a copy.
While I have not had a chance to read all the postings to this thread I have printed the thread and will respond (hopefully tomorrow). I should just like to say at this time that I would think that given the higher tax rates in Canada that the strategy would make even more sense here.
Enough for now, its 1:30am and I still have work to do before I sleep, more tomorrow (or ASAP).
Another item to think about in this inside verses outside RRSP discussion is future taxes. I have put away a good lump sum into my RRSPs, but I am seriously thinking now that all new investments will be outside. Why?
Sorry my last append was messed up, it should have said
Another item to think about in this inside verses outside RRSP discussion is future taxes. I have put away a good lump sum into my RRSPs, but I am seriously thinking now that all new investments will be outside. Why? Because 2 things seem to be constant: 1) tax rates keep going up, so all that money that is protected in my RRSP is choice picking for my government. I can not get it out or move it around without them getting theirs off the top 2) the fact of the matter is that despite all the warnings, to few people are saving enough for retirement. So like the CPP reforms that government will look to those who have saved large amounts in RRSP's and see this as easy money.
So while I do agree with the RRSP concept I think there is some prudence in growing capital gains type of investments outside of a RRSP. We can crystalize them and pay the taxes when we want and after that the money is ours to do what we want with (including moving it off shore). I would rather pay 30 some odd percent now then leaving it all in a RRSP and have 60+% tax brackets when I retire. Of course some may feel this is a negative view because of course the goverment is about to lower taxes any day :-).
One more reason U may want to keep $$$ outside RSP is the Senior's Benefit & clawbacks in OAS coming.? U have control of income outside RSP but have to take a minimum of around 7% outside in a RRIF by age 69.
I think Rob can give U more details on that. Don't U have a program called RIFmetrics that helps people to decide?
just curious why, in your example, B gets a 12 or 15% return and A only gets 10%. presumably both have access to the same investments. the real thrust of your example should have been the difference between a lump sum up front and periodic payments as you go along in terms of final amount compounded at equal rates of return.
someone elsewhere already showed that unless you are extremely lucky, dca will beat lump sum based on past returns.
anyway, my main point is the difference in your rates of return for A and B are a big part of why they end up with different amounts at the end, not the fact that one is leveraged.
this is the kind of example that can fool some inexperienced investors into using one investment method over another that they do not understand. sometimes i wonder if the FP proposing them really understands or has just copied them from the corporate sales manual.
now before all you FP's out there jump on me, i'm not tarring you all with the same brush, just Reg, who seems to think that pasting a three year old article with out of date tax rules and misleading mathematics is an example of good advice.
come on Reg, get your head out of the Florida sand where you seem to spend a good deal of your time and get up to date.
I hope the finance department has looked closely at the implications of the new Seniors Benefit that will replace OAS and CP benefits. From the information regarding the reduction of benefits to seniors above a certain income level, it will likely further reduce our country's already low saving rate. Why would individuals scrimp and save during their working life only to see the proceeds from that effort taxed 100 percent in retirment? They won't. And since in the long run savings=investment => lower output growth rates => lower living standards, the implications are much more serious than the government is portraying.
Excellent question. I like to talk to people like U who R thinkers. Sure glad U never became too abusive because I wrote the article that way on purpose. U should know by know I wouldn't carelessly make a mistake like that. :):)
Re-read my second paragraph.
But, is there a better way? How would you like to have the advantages of an RRSP without the disadvantages. Instead of deferring taxes how would you like to eliminate them and still have a tax shelter working for you in addition to making TWO to five per cent more?
What I did was illustrate 2% more to see who read my article would detect that. I received a few phone calls & told them that generally when someone invests outside of Canada, which represents aprox 3% of the world's capitalization your chances of making at least 2% more in an international fund are excellent.
I would then simply say that I would have to see the person to properly explain how it works. They would have to see & have it explained clearly to them b4 they considered such a strategy because of the many other factors that enter into such a decision.
Just curious, but what does the Clean Environment not match up against?
I do not own any, but their performance seems to be quite impressive (three of four funds top Quartile for 3 year and five year). I wish I did own some!
I concur with your opinion on Reg's affection for leveraging. Not a fair comparison (different return rates). Regal Capital planners has been a strong proponent of this strategy for many years. (I wonder how many investors got stung using this strategy to invest in the HOT Japanese sector funds in the late eighties).
In fairness to Reg, it is a decent strategy for a relatively sophisticated, informed investor, who has the discipline to hold in tough times and the cash flow to service the debt- and I believe that this is the type of person Reg is directing his attention towards.
Take a look at the Clean Environment Equity fund - a socially responsible gem!
I like leveraging in some circumstances, but it may not be responsible to assume that history will repeat itself - meaning will foreign funds continue to outperform?
We must be careful using this assumption. The Canadian $ has steadily declined relative to most currencies, increasing returns on foreign investments. If this trend continues, great... but what if it does not?
A Canadian investor will have a currency loss to deal with if our dollar appreciates to an extent. To be fair, we should use the int'l return rate assumption with a grain of salt.
snoop, I have comparisons that go back to 1981 comparing the Canadian market to other markets. Canada was never the leading stock market. 1983 was the best year for Canada with a 32.4% return. Even then other markets beat it.
I even did a comparison of the average of Canadian Equity funds as opposed to International funds over ten years & it came out to be in excess of 2% on average.
Think about it for a minute. Doesn't it make sense that if U go shopping for bargains in many different stores as oppposed to only one store U will get better bargains?
I absolutely agree that there are relatively limited choices in Canada compared to throughout the world.
My point is, How much of the outperformance of other stock markets since 1981 has been due to the devaluation of the Canadian dollar?
I believe that this should be a concern at this juncture. Sorry I dont have documentation, but our dollar has definitely fallen in relative strength to most currencies since 1981, which would contribute significantly to the outperformance of foreign markets since that time.
No hostility present, just caution- a more valuable Canadian dollar would decrease the foreign returns- in the long run, reversion to the mean happens- all other factors being equal.
Thanks for such a quick response. I wish I could find a chart which shows the currency gains from investing in foreign funds over the last 15 years. It might shed a little more light on my concern with making the +2%-5% assumption.
sorry about that last bit, it's been a bad day so far, etc. etc. shouldn't post here when i'm in a grouchy mood.
i understand now where you get the extra couple of points on the return outside the rrsp. i still have a problem though with writing articles like this that do not include the whole story.
i understand that you write your articles, in part, to increase your business. fair enough. but how many people that read your article in the newspaper did not contact you for a further explanation, but did act on the info you provided?
is there a danger that providing only part of a story, by a person who presents himself as a professional, could cause some problems for some people? do you bear any responsibility to include a caution/warning at the end or beginning of your articles to contact a professional before acting on this information?
don't know, just putting it out there for discussion.
I don't know since 1981, but since last year the CDN$ has appreciated against the yen (30+ percent), the DMark (20 percent) and most other SE Asian currencies. While it is true that our currency has depreciated a tad relative to the US$, it has appreciated relative to other major currencies. If you want to plot relative exchange rates between CDA and other countries' currencies you can find the data somewhere here. It may take a while - the IMF sources and the Fed Reserve sources contain the data you seek.
The article under consideration provides a table detailing the tax efficiency of the assets utilized in the study; I am providing a copy below. Please note that the source of the table is T. Rowe Price Associates.
Fund Performance and Tax Efficiency (20 years through 3/31/96)
RE: Could this study be an artifact of the belief that managed funds are a good investment?
Are you suggesting that managed funds are not a good investment? I should point out that the article does indicate (and I quote), "ůStock funds tend to generate higher yearly tax obligations than individual stocks. Most stock funds trade their portfolios and they're required to distribute net trading gains, which are taxable to the investors. Individual stocks, on the other hand, may be bought and held, so the only taxable income will be dividends---- inconsequential for many growth stocks. Thus a strategy of holding individual stocks outside a plan and individual bonds inside may be far different than stock funds out, bond funds in." Page 21 Financial Planning / October 1996
RE: switching equity funds that are held inside an RRSP with fixed income funds that are outside.
This is the normal or most common approach. The point of the article was to indicate that this might not necessarily be the best approach.
Re: tax issues are secondary unless.
Yes tax issues are secondary, however they are not inconsequential. You should first determine that the proposed investment is likely to be a good one in its own right. Then you consider what effect taxes may have on the investment. If there were tax consequences you would see if there were some way to neutralize or minimize the tax. If the tax consequences were to make the investment unattractive then you would not make the investment.
Re: if equities grow at a faster rate than fixed income.
You are 100% correct. The study assumes (as do most, but not all), that stocks will outperform fixed income. After all, stocks for the long term, right. As I noted above the article indicates a min. time frame of 10 years.
Re: higher tax rates in Canada.
As noted above, I would think (and I may well be wrong), that the higher tax rates in Canada would make this strategy more not less attractive. Obviously the bottom line is how much of a difference there will be between bond and equity returns (and which will be better), going forward. The problem of course is that we do not know which will be the case. Recent history (1981 to 1997) suggests stocks will perform better. However it is entirely possible that bonds may outperform over the next 10+ years (please see the table in the thread Facts Figures and Useful Tidbits "Historical Return Experience, 1929-1986"), (this may help decide what the most likely outcome will be). Of course the problem is a lot can happen in 10, 20, or 30 years. Who is to know what the best thing to do will be? I personally would not recommend an all or nothing approach. I have both fixed income and stocks in all of my families accounts. While I treat all dollars in these accounts as 'the families portfolio', each account has a different function and so must be balanced in such a way that the accounts objectives have the greatest chance of being met with the minimum risk possible. The point that I am raising, and it was a direct response to the question that started this thread is that the fixed income in / equity out approach may not be the best one. I fully agree with you that there is no one answer that fits all, but that is exactly what the rule of thumb proponent's advocate.
RE: having an equity fund outside an RSP will produce very little taxation until you redeem.
That depends on the fund, the purpose that the fund purchase is put to, and how well the fund did in any particular year. If the fund is managed by an active trader, if the fund is a sector or region specific fund that will be held for only the time that that sector is performing well, or if the market has enjoyed a major move in one year (i.e. Asian funds in 1993), then the tax owing may be considerable. Finally simply by rebalancing a portfolio after a strong year for a particular fund may generate significant tax obligations. I do not know of too many bond funds that have ever returned in excess of 50% in one year, in fact I know of none. But there are many examples of equity funds that have done much better than 50%. Thus tax consequences may be considerable upon rebalancing.
PS: the article in question deals with the subject matter in more detail than I possibly can. If you are at all interested in the subject you should try to obtain a copy.
I'm not upset when people get a little frisky. :) It helps to keep me on my feet & vital.
I've dealt with all types since 1970 when I started with London Life. At the end of all my articles I say, "If U have any questions please call me."
Anyone who just takes advise only from what they read in the newspaper must be smoking something.:)
No newspaper columnist puts a disclaimer like U suggest unless they mention specific securities. I usually refrain from doing that. I discuss strategies in general. But, I will take your suggestion to heart & make it clear in the future to not attempt to use this without consulting a professional. I often mention seeking the advise of a professional in my columns.
BWG - Thanks for the significant effort you've put into posting this information. The tax efficiency table was enlightening. The quote you provided:
"ůStock funds tend to generate higher yearly tax obligations than individual stocks. Most stock funds trade their portfolios and they're required to distribute net trading gains, which are taxable to the investors. Individual stocks, on the other hand, may be bought and held, so the only taxable income will be dividends---- inconsequential for many growth stocks. Thus a strategy of holding individual stocks outside a plan and individual bonds inside may be far different than stock funds out, bond funds in." Page 21 Financial Planning / October 1996
answered my questions very well.
Mix is the most important consideration here - with a limited base in an RRSP, only sufficient to match the fixed income component of the portfolio, then I would stick to the fixed in, equities out "rule of thumb". Further, if the investor is growth-oriented with some or all of the equity side of the portfolio, then go with a low-MER index fund or a low-turn fund or even one of the "umbrella" funds that permit 100% tax effeciency.
If you are bying stocks, then the deferral outside the RRSP is entirely controllable (divs being of minor importance in the overall return). If you are using a MF, then some surprises may arise like the $2 per Unit on Trimark Cdn or $5 per unit on Trimark Fund about to be distributed this year (see other thread on this).
Perhaps long term tax rates will come down so the bite on the ongoing investments outside the RRSP will be less. But aside from the odd high distribution from a fund that is reorganizing, is it not better to have income that is slightly better off taxwise outside rather than inside? The fixed income will be 100% taxed annually, almost as bad as a paycheque. The alternative to this is to have virtually 100% of investments in equities, then of course the discussion is moot.
While I do not have handy a chart that compares this, the concept is virtually universal (leveraging strategies aside) - but it does depend on the mix the investor needs. This said, what I generally do is look at a GLOBAL (all assets for both parters, inside and outside the RRSP) mix for the investor(s), put the equities outside the RRSP to the extent they will fit, do some foreign content in the RRSP if more equity is needed and if there is not enough of the portfolio outside to suffice the equity component do as much other Cdn equity as is needed to get to the right mix of equity, then fill in the fixed income portion using strips (laddered) inside the RRSP. I also give considration to the investment sensitivity of the investors - one partner might be ok with risk, so this is where we put the aggressive funds while the other partner's equity portion would hold the more conservative funds.
Strip coupons are great fixed income investments, but only if held in an RRSP - held outside they can create lots of tax headaches (thanks to the annual accrual rules) - using other instruments like GICs or Bonds or Bond Funds for the fixed portion will diminish the impact of compounding at the face rate of the investment and can shorten the "duration" of the fixed income portfolio. Strips have the additional advantage of simplicity and ease of access, but ony for inside a tax deferred fund.
Where equities really shine in an RRSP is where the investor is an aggressive trader and makes 30% per year trading - then the tax deferral really helps. High turn ratio management outside an RRSP can sure cause some uncomfortable moments at tax time.
Assuming reasonable (conservative) assumptions of long-term returns, equity outside the RRSP proved to be the winner in a spreadsheet I did recently. I assumed $100k in an RRSP and $100k outside. I used a 6% return on Bonds and varied the return on the equity funds, starting with 9%. I used a projection time period of 20 years. I also ran the accumulation with bonds outside the RRSP and the equities inside (contrary to conventional wisdom).
Looking at rates over the last 20 years, inflation compounded at 5.3%, cash generated a 10% return, bonds did 11.9%, the TSE 300 did 13.3%, the S & P 500 did 16.3% and EAFE also did 16.3%. One obvious advantage to having an equity portfolio outside the RRSP is the access to a greater international exposure (unless the foreign content rules get changed). But, these rates of return are past history and of course are no indication of any potential future performance, as we all know.
OK, here are some of the internal assumptions. Compounding occurs annually, bond growth at 6% is taxed at 50% when the bonds are held outside the RRSP. Equity growth outside the RRSP is taxed at 35% (to account for Cdn Dividends, foreign tax credits and capital gains taxation rates). Regardless, all the RRSP money was taxed at 50% at the end of 20 years.
One key advantage of holding equities outside the RRSP is not only the lower rates of tax on this type of income but also the potential tax deferral afforded by the "tax efficiency" of the equity investments (see other threads on this). In short, this represents the fact that most equity funds do not distribute all their income/growth every year. To this end, I also considered on top of the returns for the equities OUTSIDE of the RRSP, the potential advantage of paying tax on the return after 2 years, 3 years and 5 years during the 20-year projection (of course, if tax efficiency allows a longer or indefinite deferral period, then equities outside the RRSP have an even greater advantage).
With a 9% return on equities, the pure advantage (ignoring the tax deferral advantage) of the equities outside the RRSP is $11283, add in the advantage of 2 year tax deferral and the advantage rises to $27265, with a 3 year tax deferral the advantage is $31710, and with a 5 year deferral the advantage is $41545.
With a 10% return on equities, the pure advantage (ignoring the tax deferral advantage) of the equities outside the RRSP is <$4265> (negative, showing an advantage to holding equities INSIDE the RRSP), add in the advantage of 2 year tax deferral and the advantage rises to $17857, with a 3 year tax deferral the advantage is $23959, and with a 5 year deferral the advantage is $37386.
With a 11% return on equities, the pure advantage (ignoring the tax deferral advantage) of the equities outside the RRSP is <$25406> (negative, showing an advantage to holding equities INSIDE the RRSP), add in the advantage of 2 year tax deferral and the advantage rises to $4583, with a 3 year tax deferral the advantage is $12789, and with a 5 year deferral the advantage is $30706.
With a 12% return on equities, the pure advantage (ignoring the tax deferral advantage) of the equities outside the RRSP is <$53436> (negative, showing an advantage to holding equities INSIDE the RRSP), add in the advantage of 2 year tax deferral and the negative skew is < $13476>, with a 3 year tax deferral it's <$2631>, and with a 5 year deferral the advantage is $20974.
With a 13.5% return on equities, the pure advantage (ignoring the tax deferral advantage) of the equities outside the RRSP is <$111845> (negative, showing an advantage to holding equities INSIDE the RRSP), add in the advantage of 2 year tax deferral and the negative skew is <$52006>, with a 3 year tax deferral the it's <$35959>, and with a 5 year deferral it's <$1314>.
So unless you feel that with 2% inflation, and an expected 6% return on bonds, you expect equities to run along at over 13.5% compound annual return for the next 20 years, equities should be outside the RRSP. Remember that raising the return on equities may also mean that bond returns also run higher than just 6% annually.
Perhaps others could take a run at the concept of simulating the return comparison, in order to challenge this structural issue.
never ever make an investment because of the tax implications
OK, I reread the Rowe Price article today and it bears out the numbers I arrived at in the analysis - the in/out arguement is a function of the yield assumptions and tax rates (they used 28% in some cases - not a CANADIAN tax rate, eh) - they did not that I could see attribute any time value of compounding to the "deferral" period for tax payment due to owning equities outside the IRA or the 401(k) - in my analysis, paying tax 2 years later throughout 20 years (or 3 years later or 5 years later) adds significant value.
Any other thoughts on this?
BTW, Len I was not suggesting a tax dodge or an investmetn based solely on tax, but your advice is good - always look at the investmetn first, then consider tax advantage.
Thanks for the analysis, Warren. A few weeks ago I took a run at setting up some formulas that would model income or gains, in or out of an RRSP. Unfortunately, I got bogged down trying to adjust the equity equations to include a variable for distributions. Maybe over Christmas the relatives will bore me enough that I have time to take another run at it. Maybe we can get gummy, or jd to take an interest. In the mean time, I see no reason to disagree with the conclusions or your spreadsheet approach.
Here's some real-life support for Reg; My FP preached the benefits of leveraging and using the interest on the loan as a tax deduction rather than conventional RRSP's for several years before I had the nerve to jump in. Its hard to ignore the constant barrage of information about "maximizing your RRSP's" and depart from what all one's friends and associates are doing. But in Nov 1994 we opened a 2:1 loan, borrowing $120,000. Since then $176,000 has grown to $271,000. Removing the loan, $56000 has grown to $151,000. The interest on the $120,000 is completely tax deductible, and my income is such that I could service the debt should things go south (an important cosideration) Reg, you didn't mention one of the biggest advantages of this technique; I have a lot more money working for me than I would if I just put it in an RRSP. My FP used a model that assumed the same rate of return on the equities whether inside or outside the RRSP, and the numbers were still very favourable. Choice of funds is also important ( as someone else said, more important than the tax implications). SInce 94, I haven't put any money in RRSP's at all, and I'm comfortable with that
Peregrine, yes it works on the upside of the market because you are more leveraged (ie: roughly 68% (120/176) leveraged rather than the 40 or 50% 'leverage' that an RRSP gives you by postponing taxes, depending on your tax bracket). But you're not comparing apples with apples when it comes to risk - check out the downside!
You should also check that you have grossed up the RRSP dollars for comparison purposes. ie: if you have 5K to invest, that will fund a 10K RRSP contribution using the tax refund in a 50% bracket, or a 8,333 RRSP in a 40% bracket.
Your comparison also did not reflect the after-tax carrying cost of your 120K loan.
Bottom line: it's not as rich a strategy as you make it out to be, but if you're prepared to take the risk - it's still a good one (and one that I use). Also, at the dollar amounts you're using you may not have the income or contribution room to effectively use an RRSP.
Not to cast dispersions on your FP, but you should be mindful that the more you borrow, the bigger his/her income.
I would like to say that I am a proponent of the conservative leverage. Tax implications can be huge when you are dealing with large amounts of money.
I am currently using a combination of leveraging and RRSPs with my strategy. One does not want to have a huge RRSP just because when the time comes to convert, one is faced with a large unstoppable stream of income that has no preferrential tax treatment. With non-registered investments and as long as they are generating capital gains, one can defer the tax indefinitely.
One last thing, make sure you are working with a financial planner. I have really felt the added value with my planner.
Excellent comments. U show balance in your statements. I see U have discovered one major problem with RRSP's. The larger it becomes, the greater the tax liability in the future.
I feel they still have their place, but in a much less prominant way.
In many ways for some of our clients we don't do as much as we do for others but one thing we do for them all is to work out the tiny details & smooth the road.
If nothing else for some it is just to make things simpler. A number of them just want me to handle everything so they can get away from it all. Although they still take an active interest in it, they don't have to keep up with things as much and can leave it and have piece of mind knowing I'm taking care of the store.
Leveraging works fine for the winners however I followed Reg's advise, leveraged, bought 20/20 India and plowed some money into AIM Korea
Should I go to another bank and borrow more money to put in these funds.
Is my home sacred or should I take a second mortgage on my home to buy low?
Boy U R a real loser. Especially when I never gave anyone such advice.
"Average down" buy more ...
or was that
"Auger in" die sooner ...
Good Luck either way.
Safest non-RRSP leverage: Buy Berkshire Hathaway shares (B's only, yes "only", $1,500US)
Then very little concern about capital gains either for 10-30 years until you need money ('cause no other time is a good one to sell BRK.B)
For TJ and all others afraid of tax implications of RRSPs
Grow up. You have had years of tax free compounding. You have had tax deductions for your contributions. You paid no tax on the income in the RRSPs and you are complaining about the income you will have on retirement. Why did you purchase RRSPs in the first place, if not to replace the income you had while working?
I can't believe people like Brian Costello who are telling people to go borrow money from a bank so that they can pay interest to offset the income from their RRIF and pension funds. What a ridiculous concept.
If you don't want to pay the tax on RRSPs do all your investing without the tax advantages. You will be poorer for it but you and your estate will not have so much tax to pay.
Sorry it has taken me so long to get back into the discussion.
I would like to say that I am not advocating that you should always put equities into a tax sheltered plan (be it RRSP, IRA, or wherever), and hold your bonds outside. The T. Rowe Price article was cited as a counter to the rule of thumb - bonds in, stocks out. There is no rule that is correct at all times for all people.
The point is that it makes sense to hold the asset that will cost the most dollars in taxes inside a tax deferral plan. If the tax bill on bonds will be higher, then the bonds should be in the RRSP. If the tax bill on stocks will be higher then the stocks should be in the RRSP.
There is little point to running spreadsheets of the past relationship of the returns on stocks and bonds to try and determine which course of action is most appropriate. If you select a period when the return on stocks was far greater than the return on bonds, then you will find that holding the stocks outside of an RRSP would have cost you more tax dollars than the bonds would have. If stocks underperformed bonds for the period in question then obviously the bonds would have cost more in tax dollars than the stocks, and thus you would have been better off holding the bonds inside an RSP.
The problem of course is that we do not (and can not) know going forward which class will outperform. Thus we can not know for sure which class should be in and which outside of an RSP.
This fact does not make the discussion useless. Many individuals have simply accepted that you (as much as possible) hold the fixed income component of your portfolio inside your RRSP, and your equity component outside. It should be clear at this point that this is not necessarily the best course of action in all cases. If you accept the thesis of 'stocks for the long run', then it would seem to me that you would want to have at least some equities inside your RRSP so that their gains may be sheltered.
I personally hold both equities and bonds inside and outside of my RRSP. There are a number of reasons for my doing so. Some of them are, 1) it makes it easier to rebalance the portfolio, 2) I can hold more foreign content than if all equities were inside the RRSP, 3) in the event of a financial emergency I have a choice as to which asset class to draw funds from, 4) while I consider all of my families investments as our PORTFOLIO, I also have what may be considered SUB-PORTFOLIOS. Each of which has its designated purpose; thus each of which must take into account risk control. There are more but I think that you probably have gotten the idea.
I look forward to your (and anyone else's) comments on the above.
PS. I would like to thank all who have contributed to this thread in particular and the discussion forum in general. The whole point of the forum (at least for me) is the sharing of ideas and approaches. I appreciate those who take the time to make thoughtful contributions. This is why I enjoy returning to the forum as often as I can. I have noticed however an increase in the number of vehement attacks on various individuals or groups of individuals. I wonder if this may be due to the increased market uncertainty that we have been experiencing lately. For me at least it has, to some degree, taken away from my enjoyment of the site. I would suggest that we actively (and politely) discourage this type of behavior.
All the best to you all. I hope to contribute over the next few weeks but I am on the road at this time and am having some difficulty finding the time to log on.
I would like to take this opportunity to you wish you all the best of the season.