September 1997

Investment Strategies

© Talbot Stevens

Inside an RRSP, all investments grow tax-deferred. This makes evaluating what to put in an RRSP much simpler than investing outside an RRSP. All you need to focus on is what investment is expected to produce the highest gross, or before-tax, return.

With non-registered investments, things aren't as simple. Outside an RRSP, each type of investment is taxed differently as shown in the August 1997 Strategy Sheet. Our goal is to maximize our after-tax return — the amount that we get to keep.

Guaranteed investments that pay interest (GICs, Canada Savings Bonds, term deposits, bank accounts, etc.) have traditionally been Canadians' favourite type of investment.

If short-term safety is your primary objective and you can't afford for your investment to decrease in value, some type of guaranteed, interest-paying investment is probably best.

However, interest is the least tax-efficient type of investment. It is taxed at your full marginal tax rate.

If your investment objective is to generate income, dividends from Canadian corporations are the most tax-efficient.

After accounting for the Dividend Tax Credit, Canadian dividends are generally only taxed about two-thirds of your full marginal tax rate.

The exception is the lower tax bracket, where the dividend tax rate is about 7%. This is an overlooked opportunity, especially for those in the low tax bracket who need income, like seniors and those not working.

Because of the basic personal tax exemption, you can earn over $23,000 of dividends per year and pay no tax, if this is your only source of income. A 5% dividend produces about the same after-tax return as 6.5% of interest.

If your objective is long-term growth, capital gains are the most tax-efficient. A capital gain occurs when you sell something for more than you paid for it.

There are two tax benefits of capital gains. You only pay tax on three-quarters of your gains. While this is not quite as good as with dividends, you do not have to pay tax on capital gains until you sell for a profit. Tax on interest and dividends must be paid every year, even if you don't receive the interest.

Thus, pure capital gains have the same tax deferral benefits as RRSPs. This is a major advantage that results in significantly higher, after-tax, long-term growth.

Compare $1,000 a year invested at the same 10% before-tax returns for interest and for capital gains, over a 20 year period, for someone in a 40% tax bracket.

Simply comparing on a before-tax basis, both strategies are identical.

However, on an after-tax basis, as is the case when investing outside an RRSP, the interest-paying investment (like GICs) is worth about $39,000. The after-tax value of capital gains is over $50,000 — an increase of 29%.

Most invest for capital gains using equity funds. This is the safe, diversified way to invest for the historically higher returns of stock markets.

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