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If I'm buying stocks for the long term, should I hold them in or out of my RRSP?

You may want to own them both inside and outside your RRSP, depending on how comfortable you are holding stocks. There are several issues you should think about.

The key argument for stocks is that they've done the best job of growing in value over the long term. They're the investment type most likely to boost your buying power by keeping you ahead of inflation. Stocks should be considered if you need growth in your investments. Stocks and other investments contributed to your RRSP offer two key benefits. First, they generate an immediate tax deduction. Second, any earnings compound tax-deferred until you eventually take the money out of your plan.

If you hold stocks outside your RRSP, you do lose the tax-deferring advantages generated by using an RRSP. However, dividend income from stocks of Canadian corporations, unlike interest income from bonds or GICs, isn't taxed at your full tax rate. Also, a capital gain -- what you earn from a stock if you sell it for more than you paid -- receives a tax break too. There are also some tax advantages to holding stocks outside your RRSP. Be aware that if you transfer a stock into your RRSP, you will be deemed to have sold it. This could leave you with a sizeable capital gains tax bill. Consider this before shifting stocks into your RRSP.

Don't forget that stocks carry greater risk than fixed-income investments like bonds, particularly in the short-term. The price of stocks typically move up and down more than bonds. Stocks in Canada have historically produced average annual returns of around 10%. This average masks a bumpy road. Some years, stocks might produce returns of 25%. Other years, they may lose 25%.

This means the dollar you invest in a stock this year might fall to 75 cents next year, or may rise to $1.25. But you can lose money on bonds too, especially if interest rates rise after you buy. The risk of losing money on stocks declines as your investment time period increases. So they could be part of your investing for a retirement that's 10, 20 or 30 years away.

Stocks may not suit you at all - in or out of your RRSP - if they won't let you sleep at night. You might be more comfortable having a small proportion of your money in stocks and a greater share in fixed-income investments.

Prices of stocks and fixed-income prices move up and down at different times. If you hold some of each, this will tend to minimize rises and falls in the value of your overall investment portfolio. This balanced approach combines some protection of your capital with a bit of growth to offset inflation.

Some strong arguments can be made for holding at least some stocks in your RRSP, as we've seen. But there can be good reasons for keeping them out of your RRSP, too.

You might want to keep only fixed-income investments in your RRSP because you simply aren't comfortable holding stocks in your plan. A stock (or any other investment) that loses money represents RRSP contribution "room" that can never be replaced.

A special tax reason for holding stocks outside your RRSP has to do with reducing taxes by using capital losses to reduce capital gains. If you sell a stock for a profit, the tax on that can be eliminated or reduced if you also sell a money losing stock to create an offsetting capital loss. Canada Customs and Revenue Agency will not share these losses if these stocks are inside your RRSP.

If you're going to keep stocks in your RRSP, consider using less risky stocks - blue chip, dividend-paying stocks - as opposed to riskier small company stocks. Your riskier stocks would be outside your RRSP. You at least have the potential to use capital gains on winning stocks to offset losses on losing stocks.

Bonds and GICs generate interest income that's taxed each year at your full tax rate, the same as employment income. This is a reason for keeping them inside your RRSP so they can grow tax-deferred.

There is a tax wrinkle with RRSPs. Any money you withdraw as income is taxed at your full tax rate. At this point, even capital gains on stocks and dividends from Canadian corporations lose their special tax breaks. On the other hand, for all the years these stocks were in your RRSP, they were free of any on-going taxes.

Consider seeking professional investment and tax advice.

Feb. 2002