Investment puzzle: Inside or outside?
TFSA makes the decision a bit more complicated
Let me begin by saying there are no right answers. In fact, the age-old dilemma of which investments should be held inside versus outside your registered retirement plan has been further complicated by the addition of a third option: the tax-free savings account, introduced last year.
In an attempt to construct an ideal asset allocation, we will assume that you have a balanced portfolio consisting of some fixed-income investments -- such as bonds or GICs -- that generate highly taxed interest income, as well as some Canadian, U.S. and international equities that pay dividends and have the potential for capital gains.
How to proceed? The traditional thinking has your interest-bearing investments, such as bonds, inside your tax-sheltered RRSP, while equities, which have the potential to generate 50% taxable capital gains, should be left to non-registered accounts.
Canadian equities that pay dividends are generally best held outside of your registered plan to take advantage of the dividend tax credit (DTC), which offers a favourable tax rate on Canadian dividend income.
If those same dividends were earned inside an RRSP or RRIF, when withdrawn they would be simply taxed as ordinary income. If this seems unfair, that's because it is.
In essence, this loss of the DTC by RRSP and RRIF investors amounts to double taxation of corporate earnings, since the DTC is meant to compensate individuals for the tax paid by the corporation on its earnings before distributing the after-tax profit as a dividend.
A solution to this problem was suggested several years back by tax professor Jack Mintz of the University of Calgary, who recommended that RRSPs and RRIFs also be granted a DTC to ensure that after-tax corporate profits from Canadian corporations would not be taxed twice.
This recommendation was echoed in the Investment Funds Institute of Canada's 2009 federal pre-budget submission. It recommended allowing individual RRSP and RRIF annuitants to claim the credit personally on their returns for dividends paid into these plans.
As for foreign equities, since no DTC is available, foreign dividends are taxed as ordinary income at rates equivalent to interest income, making them better candidates for your RRSP.
One potential snag, however, is that foreign dividends may be subject to foreign nonresident withholding tax. In a non-registered account, you get a foreign tax credit for the amount of foreign taxes withheld, but if the dividends are paid to your RRSP no foreign tax credit is available and thus the non-resident withholding tax has a direct impact on your net return.
For U.S. stocks, however, there is an exemption from withholding tax under the Canada-U. S. tax treaty for U.S. dividends paid to an RRSP or RRIF. Note that this same break does not apply to U.S. dividends paid to a TFSA.