February 1997

Are Capital Gains
Better Than RRSPs?

© Talbot Stevens

The new seniors benefit forces us to re-evaluate all investment strategies, especially RRSPs, in terms of their ability to produce after-tax, after-clawback income.

The June, 1995 Strategy Sheet outlined how conservative leverage of equity funds was significantly better than RRSPs.

This Strategy Sheet and the next one will analyze RRSPs vs. unleveraged capital gains.

Often the most critical and overlooked parameter in analyzing financial strategies is the human nature factor: what do you do with the tax refund? The worst case is where none of the tax refund is reinvested.

While a tax refund spent on, say, a trip to Disney Land produces very real personal value, that vacation cannot be cashed in later to buy groceries, and therefore provides no investment value.

The other extreme is the most disciplined investor who reinvests all of the tax refund.

My informal surveying of investors and financial advisors finds that most people don't reinvest any of their RRSP tax refund.

Based on this, let's begin by contrasting RRSPs vs. capital gains for the majority who do not reinvest their RRSP refund.

Tax deduction. An RRSP produces a tax refund which, if not reinvested, results in personal value, but no investment value. Capital gains produce no tax deduction.

Tax due later. You pay tax on 75% of capital gains. The growth over a 20 year period is typically 70% of the total value. This means that the taxable amount is 75% of 70% of the total value, which is 53% of the total, compared to 100% for RRSPs.

Tax deferral. An overlooked benefit of capital gains is that the tax isn't due until you sell. In effect, capital gains have the same tax deferral benefit as RRSPs.

Restrictions and risk. Generally, RRSPs are restricted to 20% foreign content. Capital gains are not. By diversifying outside of Canada, you naturally reduce risk.

Returns. Historically, international equities have averaged about 3% higher than Canadian investments.

Limits. RRSPs face contribution limits, while capital gains do not.

Flexibility. RRSPs face forced withdrawals as early as age 69, while capital gains can compound tax deferred until death.

Collateral options. Capital gains can be used as collateral for other strategies, like drawing from a line of credit to avoid tax and clawback.

For the majority of Canadians who do not reinvest their RRSP refund, it is clear that investing internationally for capital gains is better than RRSPs.

The bottom line is to reinvest all of your RRSP refund or realize that you would be further ahead financially to invest in international equities.

Next we will quantify RRSPs vs. capital gains for the case when all of the RRSP refund is reinvested, and when it is not.

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