December 2000

Tax Cuts Mean Equities Can
Be Better Outside of RRSPs

© Talbot Stevens

In 2000, there has been a general lowering of income tax rates, and more importantly for equity investors, a significant reduction in the capital gains inclusion rate, which defines what portion of capital gains are taxable.

For over a decade, if you sold an investment for more than you paid for it, you paid tax on 75% of the gain. The federal budget in February reduced the capital gains inclusion rate to 67%, and the mini-budget in the fall reduced it back to the 50% level it was at in the 1980s.

The reduced tax rates on capital gains, and income in general, has some investors questioning if they might be better off keeping some of their investments outside of RRSPs.

The need to evaluate the possibility of unregistered investing being better than RRSPs first became apparent with the introduction of the Seniors Benefit legislation in 1996. Had that legislation gone through, most middle-income Canadians would have seen their tax rates jump from about 40% to 60% when they retired — a 50% increase.

The prospect of RRIF withdrawals facing such a significant tax increase made it obvious to me that it was essential to re-evaluate all investment strategies in terms of the goal being sought. For all but the wealthy, the real goal for most investors is to produce the most after-tax, after-clawback income over a retirement period that could last 20 to 40 years.

My After-Tax Income research showed that the 20% Seniors Benefit clawback would have made RRSPs a bad choice for most Canadians as they got closer to retirement.

For those who need proof to dispel the myth that RRSPs are always best, realize that until 1994, the tax rate on the first $100,000 of capital gains was zero, not 50%. When you could earn capital gains totally tax-free, a sophisticated computer program wasn't needed to determine whether our equity investments should be in or out of RRSPs?

Consider Sue who expects to average 9% equity returns. She is a 60-year-old in the 46% tax bracket who wants to retire at the conventional age of 65. Because of a good pension and other investments, she will remain in the 46% tax bracket after 65, and will also face clawback of her OAS payments. This effectively increases her real tax rate after retirement to 54%.

If Sue is like most Canadians and spends her RRSP refunds, she would produce about 78% more after-tax retirement income from age 65 to 85 by keeping her equity investments outside of RRSPs.

Even if Sue is a disciplined RRSP investor who reinvests every penny of her refund, she would end up with 21% more after-tax retirement income by keeping her future equity investments unregistered.

Do you want your investments reviewed in terms of which strategy produces the most after-tax retirement income?

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