Portfolio construction and registered plans

“There’s definitely a case for building up two types of accounts,” says Sandra Foster, president of Headspring Consulting Inc. in Toronto. “The RRSP account should be viewed as a personal pension plan, with the savings designed to support the contributor in old age, along with any other income from Canada Pension Plan and old-age security.”

And because RRSPs shelter any income or gains earned within the RRSP from income taxes, it makes sense to hold within an RRSP the safe, interest-bearing investments that outside an RRSP are normally subject to the highest taxation.

But deciding what goes into a non-registered account may not be so straightforward. It depends on how the client plans to use those additional investments. Because some growth will be needed to keep up with inflation — particularly if the client has the luck of longevity and the good health to enjoy an active lifestyle in retirement — those savings may be needed to augment retirement.

“The key is to maintain a balanced portfolio overall within the two accounts, while keeping the investments that are taxed advantageously outside an RRSP,” says Bill Bell, president of Bell Financial Inc. in Aurora, Ont.

Clients often want to manage all of their accounts the same way — be they inside or outside an RRSP — and to hold a mix of stocks and bonds in both accounts if their goal is a balanced portfolio, he says: “But if they hold lower-risk interest-bearing securities in an RRSP, and the more volatile equity holdings outside, that brings them back to medium risk and balance, but with better management of the tax consequences.”

When money is withdrawn from an RRSP or RRIF, it is taxed as regular income, whether it was earned as interest, dividends, capital gains or return of capital, or whether it came from a stock, bond, GIC or less traditional investment, such as an income trust or principal-protected note. Therefore, if investors hold certain investments within a registered plan, they lose the tax advantages that apply to that income when those investments are held outside an RRSP.

For example, within a registered plan, investors cannot take advantage of tax breaks such as the dividend tax credit, 50% inclusion rate for capital gains and the foreign tax credit on any taxes withheld on foreign investment income. In addition, realized losses on securities held inside an RRSP cannot be applied against capital gains from past, present and future years to reduce the net taxable gain, as they can outside the plan.

Allocation decisions are also often influenced by an investor’s age, other sources of income and risk tolerance. If a client is growth-oriented and wants only a 20% holding in fixed-income securities overall, he or she will probably end up holding stocks or stock funds in both the RRSP and the non-registered accounts. Outside an RRSP, taxes can be minimized by holding equities for the long term or by sticking to low-turnover mutual funds, deferring the realization of capital gains and the income taxes that they generate.

Or the investor may opt for corporate-class mutual funds that allow tax-deferred transfers among funds within the same corporate structure and which tend to have lower annual taxable distributions than regular funds because of the ability of the corporate-class funds to balance profits and losses from the various funds within the structure.

Bell suggests clients may want to build up an account outside an RRSP simply because the limits on RRSP contributions may not be enough to allow the RRSP to grow big enough to finance the client’s desired lifestyle in retirement.

“If a client has an annual income of more than $100,000 during his or her working years, the RRSP may not be able to replace this income due to the contribution limits,” Bell says. “Many high-income people want to maintain or exceed their pre-retirement lifestyle, and may need more than their RRSP to finance [that].”

@page_break@As well, some securities, such as hedge funds sold as limited partnerships, are not RRSP-eligible, so a client who wants to hold these may be restricted to the non-registered side of the investment ledger. Another incentive to build up funds outside an RRSP is the potential clawback of old-age security benefits if retirement income exceeds a threshold of about $60,000. Due to the preferential tax treatment accorded to equities, some clients are questioning whether they are better off at some point to forgo making RRSP contributions and build up an equity-based account outside an RRSP to avoid clawbacks.

“Some people may have a multi-million-dollar RRSP because they’ve made huge profits on oil and gas ventures, tech stocks or they’ve hit some other jackpot,” says Jamie Golombek, vice president of taxation and estate planning at AIM Funds Management Inc. in Toronto. “When they convert their RRSP to a RRIF, they will need to make withdrawals at prescribed rates. Advisors can play a huge role in projecting the future retirement income stream and deciding whether or not to continue putting money into an RRSP.”

There are many repercussions to this strategy, and investors and their advisors need to think carefully about forgoing the RRSP’s advantages in favour of non-registered investing, Golombek says. It’s important to remember that the RRSP generates a tax refund that significantly reduces the after-tax cost of the contribution.

In addition, tax deferral on growth and income provided by an RRSP continues even after it is converted to a RRIF in the year the holder turns 69, as long as the assets remain in the registered plan.

“By diverting money out of an RRSP to avoid a future clawback, investors could be giving up a lot of tax deferral for the next 30 years, and may be giving up more than they’re gaining from avoiding a clawback,” says Myron Knodel, manager of tax and estate planning at Investors Group Inc. in Winnipeg.

RRIFs must be gradually depleted until they are finally wound down in the year the holder turns 99, and investors could be giving up many years of valuable tax-deferred growth by limiting the amount of contributions to the registered plan, particularly if they want to hold a lot of fixed-income securities to provide a reliable income. IE