Category: Investing

Recently I wrote a post about the benefits of RRSPs and showed a simple model comparing a dividend stock in a rrsp versus a non-registered account. In that model, the rrsp investment came out ahead.

Today I want to cover another scenario which involves an investment that has capital gains and no dividends. We’ll compare what happens if this investment is held inside an rrsp or in a non-registered account. In this case there is no “tax drag” from annual dividends.

One of my favourite readers, “Telly” pointed me to an excellent article that covers this very scenario on martingale’s site. This article explains exactly why the investment in the rrsp does better than outside the rrsp much better than I ever could. Basically he is saying that since the money in the non-registered account has already been taxed once (when it was earned), any taxes (interest, dividend or capital gains) are double taxation. The money in the rrsp has never been taxed so even though it’s taxed as income upon withdrawal, it comes out ahead of the non-registered investment because it is only taxed once.

In the attached spreadsheet I did a fairly simple model for this scenario. Martingale’s article uses the proper equations but I like to see the numbers year-by-year on a spreadsheet. In this case I used a $10,000 contribution into the rrsp and there is 40% tax deferred. In the non-reg account, there is only $6,000 because the 40% tax was paid upon earning it. After 20 years the investments in both accounts are sold while the investor is still working. This isn’t perfectly realistic but it keeps it simple.

At the end of 20 years the proceeds of the rrsp account are $27,966 and the non-registered account is $23,573. The rrsp account ended up with an after tax return of 8% and the non-reg got 6.3%. The rrsp account ended up with 19% more money than the non-registered account.

I think the moral of this story is that when considering the differences between rrsp accounts and non-registered accounts we have to remember that the non-registered money has already been taxed at the marginal tax rate of the investor. A lot of investors (including me) intuitively think that because the rrsp money is taxed at the marginal rate upon withdrawal that unless you are in a lower tax rate in retirement (when the money would be withdrawn), you might be better off having the money in a non-registered account. Clearly this is not the case.

As far as long term investments go (ie retirement money) you should put this money into an rrsp if possible and only invest outside the rrsp if there is no more room.

I was asked recently by the Money Gardener about what my overall investment plan was. This was a good question because although I have talked about my various investments and ideas in a number of posts I never did a good summary of what I’m trying accomplish.

Basically my goal is to retire at age 55 or thereabouts (I’m 39 now). According to my estimates and calculations, we can retire on an income of $46,000 in 2007 dollars which will give us about $40,000 net after taxes. With this income we can live the same sort of life we live now using about $30k/year and the remaining $10k will go for vacations, spending, unexpected costs etc.

To achieve this, we are working on several fronts.

1. Pay off the mortgage. Currently at $181k and dropping. This has to be zero before retirement.
2. Use up all my rrsp room. Currently I contribute about 75% of my available annual rrsp room. Once the mortgage gets a bit lower then this figure will go up. I have about $40k of unused room so that will get used up as well. I’m a huge fan of rrsps and I think if you are in a higher tax bracket then they represent free money. Current rrsp value is about $230k.
3. Leveraged investing. We have a modest leveraged investing plan which involves dividend stocks. I don’t expect this to be instrumental in our retirement planning but we’ll see how it goes. Current value of leveraged stocks is approx. $20k.
4. Planning and monitoring. I’ve done a few basic spreadsheets (and posts) about simple retirement planning. I will continue with this series to get to more realistic scenarios. Obviously I will be doing these exercises using our data and that should tell us when we can retire.
5. Education. I will continue to read books, blogs, and any other sources that offer information about retirement related financial activities such as investing, retirement taxes etc.

Investing Style:

I generally favour a low-cost passive investing style. Currently our money is mostly in ETFs, low-cost mutual funds, some GICs, and we own a few stocks directly in the leveraged account. I don’t believe that I can pick stocks that will do better than a passive index however for the leveraged plan, buying individual stocks works out better because we need a minimum dividend in order to help pay the interest costs.

 As far as the financial debate goes between buying vs renting, it’s all about assumptions.Anyone who bought in the last 10 years in the various real estate hotspots (in Canada at least) will have done well and can use that as proof that home ownership is a great investment.However, nobody knows how much houses will go up in the future.The reality is that if they only appreciate by their long term increase of inflation + 1, then they are not such a great investment.

Dividend stocks are the same thing – they have done so well over the last ten years that everyone (including myself) is buying them now convinced that we can’t lose with them.Again the reality is that if the dividend increases over the next 10 years are more in line with their long term average of about 5% and the stocks are currently priced for more than that, the stocks won’t be such a great investment.Admittedly not a bad investment either, but anyone trying to do a Derek Foster starting now is almost sure to be disappointed.

The fact is that a lot of investments such as real estate and dividend stocks tend to do at least reasonably well over the long term in that they tend to go up in value.The problem is that we tend to think of “good investments” in relative terms so they are investments that do better than the average investment.Over the long haul, “investing” in your house probably won’t do as well as investing in the stock market and likewise, Canadian dividend stocks probably won’t outperform the market over the long haul, but that is real hard to believe given their history over the last ten years.

And finally a quote from Bernstein who is referring to the tendency of investors to look at recent history and conclude that it will continue forever, “Ignore the last ten years!”.

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.

The Bank of Montreal (BMO) raised their dividend to $0.70 today from $0.68 which is up from $0.65 that was paid out earlier in the year. This stock is the only stock in my leveraged portfolio and since one of the cornerstones of my leveraged plan is dividend increases, I was pretty pleased. In 2007, BMO has raised their dividend by 7.7% which is above my long term assumption of 5% annual dividend growth. The current yield based on today’s closing price is 4.26% which is pretty good especially if you are doing a leveraged plan like I am and need some dividend income to cover the interest costs.

An excellent website called Dividends Matter has an analysis on BMO which is worth checking out.

Now they did have a bit of an earnings drop but considering it was mostly from a trading problem which has ended (although they keep reporting losses from it) so I’m not worried about it.

Yesterday I posted a review of chapter one from Richard Bach’s book “Smart Couples Finish Rich”. Coincidentally, Brip Blap is hosting a book giveaway with Bach’s book as the main prize – so head on over and leave a comment and you might win this excellent book.

In other news I entered the latest Carnival of Personal Finance hosted by Free Money Finance so go check it out! I haven’t actually read any of the other posts, other than the ones from blogs I normally read so if you find any good ones, please let me know.