This little project was done in Nov 2000 when I needed to convince a skeptical colleague about whether it is better to have capital gains inside or outside of an RRSP account. I thought you might be interested in reading this so I decided to move it to this " Despository. "

Terminology

Inclusion rate: portion of an income that is included in your income tax as taxable income. Salaries, pensions, interest income all have an inclusion rate of 100%. That is , for $1 earned in interest and salary, $1 is added to your taxable income.

   Dividends from a Canadian corporation have an inclusion rate of 125%. For each dollar of dividend earned, you added 1.25 to your taxable income. However, dividends from a Canadian Corporation entitles you to a dividend tax credit and you will end up keeping more money for every $1 of dividends from a Canadian Corporation than you would from $1 of interest.

    Capital gains have an inclusion rate of 50% (as of Oct 2001). This means that for every $1 of capital gains, you need only to include 50 cents in your taxable income.

Marginal Tax rate: This is the income tax on the last dollar earned. Despite the new hmm...lower tax rates, the marginal tax rate is still way up there for Quebec taxpayers. The marginal tax rate for a taxable income of between 60K to 100K is about 47% and 51% for over 100K.

   The conventional wisdom is that since money earned inside an RRSP account is tax-deferred, your money will grow faster because the growing capital is not diminished by income tax.

    One must remember, however, that eventually the money will have to be deregistered. When the money is taken out of the RRSP, whether it be in a lump sum, an annuity or an RRIF, it will be taxed as income at an inclusion rate of 100%. Assuming that your marginal rate is 50%, then for every dollar you take out, you get to keep only 50 cents. On the other hand, if the money had been invested outside of an RRSP, the capital gains portion enjoys a reduced tax rate because the inclusion rate for capital gains is only 50%. Again, assuming that your marginal tax rate is 50%, then your total tax burden is only 50%x50%=25%.

    Another fact that you have to keep in mind is that any capital loss suffer inside an RRSP cannot be used to offset a capital gains, like the case when it is held outside of an RRSP.

   There is no agrument that it is always more advantageous to hold anything that has an inclusion rate of 100% : interest, US dividends, mortgage funds etc.. inside an RRSP, but when it is a matter of capital gains, things are not so clear cut. The following table illustrates what happens when $100,000 is invested inside and outside of an RRSP, at the average return of 15%. I know that the table is confusing, so look only at columns H and I and in the rows when the numbers turn negative.

    In the example below, you will see that the numbers turn negative , in Column I, in year 12. This means that if you leave your money in your RRSP for over 12 years, then de-registered and buy into an annuity, you are better off than having the money invested outside of an RRSP. All these are based on the assumption that you enjoy a capital gains of 15% per year. Dream on !

   For a period of less than 12 years, it is, in this example, more advantageous to have the money invested outside of an RRSP : again I am talking only about the capital gains type of investment.

How to read the table:
I: Assumptions:
ROC=Return on Investment 15% (This number is fictitious :-) )
Capital= $100,000 (exact amount is not important. You can just pro-rate all the numbers.):
Inclusion rate for capital gains tax=50%
Marginal tax rate=50%    , Marginal tax rate for RRSP withdrawal as an RRIF or annuity=40%

II:Table : (If you are totally confused, look only at the last two columns: H and I)

Column A	Number of Years
Column B	How much the capital would have grown to, if left outside of an RRSP. (After capital gains tax has been paid.)
Column C	The accumulated capital gains of the amount in column A, after tax has been paid.
Column D	How much the capital would have grown to, if left inside an RRSP.
Column E	The accumulated capital gains of the money inside the RRSP. Notice this is larger since no tax has been paid on it
Column F	What happens to the amount in E, if you collapse and withdraw all your RRSP money in that year. Notice I only calculate the after tax amount of the money in column E since we will be comparing only the capital gains amount and not the capital. Although the capital in the RRSP is also taxed upon withdrawal, it had earned you a tax reduction whhen you contributed; the two action cancels each other. The marginal tax rate used in this calculation is 50%.
Column G	:  What happens to the amount in column E if RRSP is withdrawn as an annuity or an RRIF. In that case, the income per year would be less and the tax rate would probably be less. So I used a slightly lower marginal tax rate: 40%.
Column H:	Column C(outside of RRSP) Minus Column G (inside of RRSP): This is the difference between (i) the net (after tax) capital gain from your capital when it is invested outside of an RRSP and (ii) when it is inside an RRSP and de-registered at the end of the given period. In the example below, in year one, the amount is $3750. This means that had the money been invested outside of an RRSP, it would have made $3750 more than the money left inside an RRSP for 1 year, then withdrawn and be taxed fully at a rate of 50% instead of an inclusion rate of 50% plus a marginal tax rate of 50% (effective rate=25%).
Column I	Same as column H, except the comparison is done for the case when the RRSP is withdrawn in the form of an annuity (or RRIF), the assumption here is that the income would be a lot less and therefore your marginal tax rate would be slightly less. I don't know if a 10% difference between the 2 rates used in Columns H and I is justifiable. In the example below you will be $2250  ahead if you had invested your money outside of an RRSP.    When the numbers in Columns H or I turns negative, that means it is more advantageous for capital gains type investments to be hold inside an RRSP. What's the conclusion: If you are near the time when an RRSP is to be cashed out, and if you had a choice, it is better to invest your money outside of an RRSP...or at least until the tax laws are changed again.

Note: This calculation is done with an ancient DOS-based spreadsheet :Aseasy-as Version 4.0 (1989 version)

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