Last time, we made a distinction between saving in vehicles that pay low amounts of interest (money market mutual funds, bank GICs, treasury bills etc.) and stocks or equity funds.
Another way to look at this is that the first group are “loaners”, while the second are “owners.” Loaners have relative security in that they generally expect to get their principal back, plus a modest amount of interest. Unfortunately, the interest they receive is rarely enough to compensate for inflation, and outside tax shelters, interest is taxed at the highest marginal rate.
Owners, on the other hand, have a real stake in the corporations that issue the stock in which purchasers of shares participate. Profits ultimately result in higher earnings and ideally dividend payouts that these days often exceed the amount of interest paid to loaners. Plus, if you pick so-called “dividend aristocrat” names, you have a reasonable expectation that over time these dividends will be raised, providing at least a shot at keeping up with or beating the rate of inflation. The bonus for owners, at least of qualifying Canadian dividend-paying stocks, is that outside registered plans, the tax rate on those dividends will be about half the rate on interest – because of the dividend tax credit.
Investors who believe in proper asset allocation – a balanced mix of both stocks and bonds – should also consider the related topic of asset “location.” Because of the different tax treatment accorded owners and loaners, it makes sense to hold certain investments inside tax shelters like the RRSP and TFSA, and others outside.
Because interest is taxed so harshly, you should strive to put all cash, bonds and bond funds inside an RRSP or TFSA. As noted above, Canadian dividends are better held outside these plans, in so-called “open” or “taxable” investment accounts.
U.S. and foreign dividends do not generate the Canadian dividend tax credit and their dividends are taxed at the highest rate like interest. So ideally they should be held in an RRSP, where they also do not attract the 15% foreign withholding tax that occurs in non-registered plans or even in TFSAs.
What about stocks that don’t pay dividends? In this case, the only expectation of a return to these “owners” is capital gains. Capital gains taxes are paid only when you realize a profit so you can hold either Canadian or foreign non-dividend-paying stocks outside registered plans and defer tax indefinitely as long as you don’t sell.
That frees up more room in registered plans for bonds and foreign dividends. But what if you don’t have enough money to maximize both your RRSP and TFSA? We’ll look at that next time.
Jonathan Chevreau is the National Post’s columnist and author of Findependence Day.