One of the benefits of an rrsp in that any capital gains or dividends are sheltered from tax as long as the money is in the rrsp. Investors who are doing a Derek Foster Maneuver or someone who just isn’t convinced of the benefits of an rrsp might be in the situation where they have unused rrsp room and securities outside the rrsp which are generating dividends and/or capital gains.
I’ve read in a number of books (including Four Pillars) that mention how the drag on performance from any kind of ongoing taxes such as dividend tax can be significant so I decided to see for myself how much effect dividend taxes have over 20 years.
To set up my spreadsheet I’m assuming that an investor has $100,000 of gross income which they can either put directly into an rrsp (no tax deducted at the source) which will result in a portfolio of $100k or they can choose to receive the $100k as income which will result in a portfolio of $60k after their 40% income taxes are paid.
I’ve made up a stock in which the purchases will be made. This stock will have 4% capital gains each year and pay a 4% dividend which will be reinvested. The dividend will be taxed at 20% in the taxable account.
At the end of 20 years, the investments will be sold in both portfolios, taxes will be paid and then the final amounts will determine which is the best way to invest. I’m assuming that when the securities are sold that the person is still working and will pay 40% income tax on the rrsp and will pay 20% on the capital gain in the taxable account (50% of capital gain * 40%). Note that neither situation is all that likely to occur in practice since good tax planning would dictate that you should wait until retirement to cash in the rrsp or sell the securities in the taxable account. However this method will allow us to isolate the effect of the tax on the dividends since all other factors will be equal.
In my spreadsheet, the first few columns are the rrsp account, this is a simple calculation – I basically add 4% cap gain + 4% div to the balance each year which results in total of $466,096 after 20 years. I’m assuming the dividend is paid at the end of each year. The income tax will be 40% of $466k which will leave $279,657 for the rrsp holder.
The taxable account calculation is a lot more complicated since I need to deduct the tax on the dividend each year (it gets paid from the dividend) as well as calculate the adjusted cost base of the investment (hopefully I’ve done this correctly) for the purpose of knowing how much capital gain there is. In this account the investor ends up with a total of $204,813 which is less than the rrsp account.
In summary the rrsp investor ends up with 37% more money at the end of 20 years which is quite significant. The investment rate of returns are 8.0% for the rrsp investor and 6.3% for the taxable account investor which is a big difference considering the only difference between the two scenarios is the tax on the dividend which doesn’t seem like a lot of money on an annual basis.
Given that the ending is not that realistic, I wouldn’t rely too much on these findings, however they certainly point to the conclusion that holding investments inside an rrsp is better than outside even if those securities have special tax considerations outside the rrsp such as dividend stocks. Active traders should also take note – they might be better off having their trading stocks inside their rrsp and their bonds outside their rrsps!
p.s. I’m working on a more complicated spreadsheet which will do the same scenario except that it will involve a more realistic scenario of collapsing the portfolio over five years. I’m not going to promise to finish it since it’s turning into a monster but I’ll see if I can at least figure out if the results will be different than the simplified scenario above.