Investments Part 2: Open [Non-Registered]

The second vehicle that people can use is the Open or "Non-Registered" vehicle. This is pretty much everything that is not within an RRSP or a TFSA.

The basics of the non-registered vehicle are as follows:

Pros

- No limit to amount of contribution
- No witholding tax upon redemption
- Withdrawal amount does not get added to earned income
- You are taxed ONLY on 50% of capital gains (i.e. You invest $100, and it turns into $200, you are only taxed on $50 --> ($200-$100)/2 )
- No age limit

Cons

- No tax deduction for contributions
- You invest with after-tax dollars
- You must declare any distributions as a part of earned income, whether or not you took them in cash

As you can see there aren't as many rules and regulations for the non-registered investment and there are some pros and cons for this vehicle as well.

If we were to do a dollar-for-dollar comparison between RRSP investing and Non-Registered investing - assuming same rate of return, tax brackets, investment timeline etc.. - RRSP will always win because of the tax-sheltering, tax deductions and tax refunds.

Example.

Lets take a look at an investor who's investing $5000/year for 20 years at a rate of return of 10%. Assumed Marginal Tax Rate is 35%. [all values will be rounded to nearest dollar]

RRSP
After 20 years @ 10% return, the investment will become approximately $315,012. When it comes to withdraw the money, the funds will be taxed fully at the MTR (marginal tax rate) of 35%.

$315,012 x 0.35 = $110,254
$315,012 - $110,254 = $204,758

Therefore, after taxes, the investor is left with approximately $204,758.

Non-Registered
After 20 years @ 10% return, invested will become approximately $206,745. When it comes to withdraw the money, the funds will be taxed at the MTR on only HALF the capital gains.

$206,745 - $100,000 [total invested --> 20 years x $5000/yr] = $106,745 --> Capital gains
$106,745 / 2 = $53,373
$53,373 x 0.35 = $18,681
$206,745 - $18,681 = $188,064

(Calculations came from http://www.mackenziefinancial.com/calc/jsp/RegNonReg/rrsp_vs_non_rrsp.jsp)

As you can see, when we compare dollar for dollar investment, then RRSP will beat out non-registered -- in this case, using the RRSP strategy, the investor would have approximately $16,694 more then the Non-Registered Strategy. This is because the RRSP is growing tax-sheltered and the Non-Registered is not; there are taxes paid annually.

Also to note, that the RRSP is getting a tax refund, so if the investor were to contribute the amount they received back from the government, the RRSP would have accumulated a lot more. But there also other strategies you can use for that tax refund, like paying extra on mortgage, or investing that refund into a TFSA (Tax-Free Savings Account - which I will discuss in the next post).

In the previous example we compared dollar for dollar investment. But, is that the only strategy? No, it is not. There is also the concept of 'leveraging' -- borrowing money to invest. The OPM (other peoples money) Strategy is something the wealthy (and all banks and corporations) have been using for years and years.

Leveraging

Pros

- Starting with a larger sum of money
- Money will grow faster
- Can have options to pay 'interest only' on the leverage loan
- Get a tax deduction for the amount paid in interest
- Money is growing as compound interest vs. interest being paid is simple interest
- Can benefit from tax-deferred compound growth

Cons

- If investments tank, you are still liable for the amount of loan that you took
- If interest rates rise, your payment will increase (however, so will your tax deduction)
- If you get a 'margin call' loan, the lending institution can call the loan at any time and you are required to repay it

Leveraging is also more suitable for those who have higher risk tolerance and longer investment horizon (I would say at least 7-10 years).

Example.

Now lets compare RRSP vs Leveraging for Non-Registered. We will use the same RRSP situation as above and assume that on a $100,000 leverage loan @ 5% interest, the interest charges will be $5000 [using round numbers to make calculations easier and more accurate to compare)

RRSP
After 20 years @ 10% return, investing $5000/month, the investment will become approximately $315,012. When it comes to withdraw the money, the funds will be taxed fully at the MTR (marginal tax rate) of 35%.

$315,012 x 0.35 = $110,254
$315,012 - $110,254 = $204,758

Therefore, after taxes, the investor is left with approximately $204,758.

Leveraging
Lets assume that an investor borrowed $100,000 at an interest rate of 5% - this means the interest payment will be $5000/year. At 10% rate of return, the investment will grow to approximately $672,750. Now lets say you are ready to retire and want to pay back the loan.

$672,750 - $100,000 [loan amount] = $572,750 Capital Gain
$572,750 / 2 = $286,375
$286,375 x 0.35 [MTR] = $100,231 [taxes payable]
$572,750 - $100,231 = $472,519

Therefore, after taxes, the investor is left with approximately $472,519.

As you can see, the leveraging strategy works out a lot better then the RRSP strategy; in fact, with leveraging, the investor would have made $267,761 more, then if he would have invested the same amount of money into an RRSP -- that's more then twice the amount of the RRSP!

If we were to put a twist on this, and assumed that the RRSP investor also invested his tax refund of $1750 ($5000 x 0.35) right back into his RRSP, making his annual contribution $6750, the RRSP would grow to approximately $425,267. After taxes, the investor would be left with approximately $276,424, which is still way behind the leveraging strategy.


(Calculations came from http://www.mackenziefinancial.com/calc/jsp/RegNonReg/rrsp_vs_non_rrsp.jsp)

That being said, be very careful with leveraging. It is NOT suitable for everybody. It requires a high risk tolerance and the investor must give time for their investment to compound over and over. Just as the RRSP is not right for everybody, the leveraging strategy is not either. Please consult your financial advisor before making any decision like this.

What might make sense is to do both strategies or mix and match different strategies together.

If you require any more information please do not hesitate to contact me!