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New dividend rules could change your RRSP strategy

What do you buy a person who has everything? My mother-in-law has everything. I know just the gift: A funeral plot. It's not that I wish my mother-in-law any harm, but she had been wanting some help with her estate planning -- which includes funeral planning -- so I bought her a funeral plot two years ago for her birthday. It cost me a thousand bucks (a pretty generous gift, if I do say so myself).

Last year, I was stumped again for a gift idea. As it turns out, I didn't buy her anything in 2005 -- and she noticed. "Tim, it's not like you to forget a birthday. What happened?"

"Well Mom," I replied, "you still haven't used the gift I bought you last year." Fortunately, she has a good sense of humour.

This week, Canadians were handed a gift when Stephen Harper announced that the Conservatives would not change the proposed tax rules that deal with eligible dividends from certain corporations (generally, public companies).

The "gift" lies in the fact that Canadians can now move full-steam ahead with their tax planning for 2006 without the concern about how a Conservative government might change those proposed tax rules if they win the coming election.

So, let's consider the implications of these tax changes for Canadians choosing investments for their registered retirements savings plans.

The past

There has always been a debate about whether you should invest inside or outside an RRSP. The debate has focused on the fact that every dollar withdrawn from an RRSP is fully taxable, whereas you're taxed on only half the growth (and on annual income) on investments outside an RRSP. My advice in the past, for the average Canadian, has been to build up enough in your RRSP to provide the lifestyle you're looking for in retirement. To the extent you're going to invest more than what's necessary to provide that lifestyle, consideration should be given to investing outside a registered plan provided you can replace that RRSP deduction you'd otherwise be entitled to (perhaps with an interest deduction on money borrowed to invest).

The present

So what has changed now that there are new proposals around the taxation of eligible dividends? Much has changed. Given the new, lower marginal tax rate on eligible dividends, it would actually be a mistake for some investors to hold all of their stocks in their registered plans, if those stocks pay eligible dividends. That is, to the extent you want to hold equities in your portfolio, you may be better off holding certain equities outside your RRSP or registered retirement income fund even if you have the contribution room to hold those assets inside the plan.

Consider this: The dividend tax credit has been increased under the new proposals so much that the credit will not only offset the tax owing on the dividend received, but will go further and will reduce other income you have as well. For example, a taxpayer in Ontario earning $60,000 annually will pay $13,703 on that income (2005 tax rates). Add $5,000 of eligible dividends to his income, and his total tax bill drops to $13,653. Did you catch that? The marginal tax rate on those dividends is actually a negative number. Now, once your income hits a certain level ($61,940 in Ontario at 2005 tax rates), your eligible dividends will increase your taxes -- albeit at a lower rate than other income.

As we head into this RRSP season, remember that the new dividend rules should have an implication for which investments you hold inside and outside your RRSP.

Tim Cestnick is a principal with WaterStreet Group Inc. and author of Winning the Tax Game among other titles.

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