Asset location: Do low interest rates change the rules?

Hold GICs outside your RRSP.

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From the December/January 2014 issue of the magazine.

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The traditional advice is to keep fixed income in your RRSP and (once you run out of contribution room) to hold stocks in a non-registered account. But it’s possible to come up with scenarios where the opposite asset location can result in a lower overall tax bill.

Sheltering interest income becomes more attractive when rates are high because there is more to shelter. But rates today are extremely low compared with the historical average. If you’re earning 2% on a GIC, your annual tax bill amounts to just $8 on every $1,000 invested even if you’re in a 40% tax bracket. Now consider $1,000 invested in a penny stock that shot to the moon and is now worth $20,000. When you sell it, you’d pay $3,800 in capital gains taxes. So if the goal is to shift the most potential growth into tax-sheltered accounts, an RRSP looks like a better home for high-growth stocks than low-yielding fixed income.

Dan Hallett, vice-president and principal at HighView Financial Group in Oakville, Ont., is no stranger to spreadsheets and has run these numbers many times. Hallett says it’s impossible to know in advance which strategy will be optimal: any decision depends on how your investments ultimately perform, as well as your tax bracket today and during retirement. But for now, he says, high-income earners may be better off holding fixed income outside their tax-sheltered accounts. “If interest rates rise sufficiently, conventional wisdom may well be the right advice again at some point,” he says. “Or if we have a bear market, that will likely be an opportune time to hold stocks in registered accounts since their expected return will be higher.”

Justin Bender of PWL Capital agrees it can make sense to hold low-yielding GICs in taxable accounts, but he stresses most bonds are currently trading at premiums, and can easily suffer negative after-tax returns.

Filling your RRSP with high-growth investments could also result in very large forced withdrawals when you eventually convert your account to a RRIF in retirement. Those large withdrawals may be taxed at a high rate, and you’ll have no flexibility around when to take them. “You can, however, make a case for placing your highest-return assets in your TFSA,” Hallett says. “There are no worries about the account getting too large, as there are with RRSPs.”

For the average investor, it still makes sense to stick to the conventional wisdom and shelter your fixed income (especially bonds) in an RRSP or TFSA. But wealthy people in a high tax bracket should seek expert planning advice to see if there might be a better strategy. “It’s not a set-and-forget decision,” Hallett says. “It must be revisited periodically as the key factors change.”

One comment on “Asset location: Do low interest rates change the rules?

  1. Why conclude that average investors should do the counter-productive thing, while wealthy should optimize tax-sheltering?

    The generalized conclusion that equity generally results in larger benefits in the tax shelters because of their higher growth. But it all depends on your tax bracket. At the lower brackets dividends may be tax-free. And buy-and-hold capital gains that are not realized for a decade may result in quite small effective tax rates on equities. While debt securities may be higher-yielding junk bond attracting more tax.

    It all depends. Use the spreadsheet and read the discussion at http://www.retailinvestor.org/rrsp.html#taxfree

    Reply

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