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investor clinic

Some investing myths die hard. Today, my goal is to kill off one myth once and for all.

After my column showing that a real estate investment trust (or any investment) will deliver a higher after-tax return inside a registered retirement savings plan, several readers "disagreed" with my conclusion.

One reader – an investment adviser – even provided an example that purported to show that holding the REIT in a non-registered account was the better option, supposedly because the REIT receives certain tax breaks. I've heard the same argument countless times, not just about REITs but also about dividend stocks (due to the dividend tax credit) and growth stocks (because capital gains are taxed at half your marginal tax rate).

I'm going to share the adviser's example, then I'm going to ask readers to hunt for the mistake in his analysis.

Imagine you're an investor who has $100,000 in your RRSP and $100,000 in a non-registered account. You must invest one account entirely in an REIT, and leave the other in cash that earns nothing. After one year, you sell the REIT, withdraw the funds from your RRSP and pay all taxes.

The question is, should you hold the REIT inside or outside your RRSP?

We'll assume your marginal tax rate is 50 per cent. Further, we'll assume the REIT returns 16 per cent before tax (from capital growth and distributions) and 11.5 per cent after tax.

Let's look at how the two scenarios would fare:

Scenario No. 1: If you hold the REIT in your non-registered account, at the end of one year your $100,000 would have grown to $111,500 after-tax. Add that $111,500 to the $50,000 withdrawn from your RRSP ($100,000 less 50 per cent in tax), and you would end up with $161,500.

Scenario No. 2: If you invest $100,000 in the REIT in your RRSP, its value would grow to $116,000, which – after withdrawing the funds and paying 50-per-cent tax – would be worth $58,000. Add the $100,000 in the non-registered account, and you'd have $158,000.

Result: Scenario No. 1 wins because it returned $3,500 more than Scenario No. 2. But does this prove that a REIT will produce a higher after-tax return if it's held in a non-registered account? Not at all.

Before reading further, see if you can spot the flaw in the above analysis. Many people can't see it at first.

Here's the flaw: In Scenario No. 1, you're investing $100,000 of after-tax dollars in the REIT. However, in Scenario No. 2, you're not actually investing $100,000. Assuming a constant marginal tax rate of 50 per cent, half of the money in the RRSP actually belongs to the government. Therefore, in Scenario #2, you're actually investing only $50,000 of your own capital in the REIT.

So of course Scenario #1 produces a higher return: You're investing twice as much after-tax money! It's a loaded question, because if you choose to keep the REIT in your non-registered account, you are also choosing – based on the way the question is presented – to make a much larger investment.

All the adviser's example proves is that if you invest $100,000 at 11.5 per cent (the REIT's return outside the RRSP), you'll do better than if you invest $50,000 at 16 per cent (the REIT's return inside the RRSP).

This leads to another key point: Your own money – excluding the government's share – grows completely tax-free inside the RRSP. Not so if the REIT is outside the RRSP.

Returning to the example, outside the RRSP the REIT is actually taxed at 28.125 per cent [(16-11.5)/16]. Thanks to preferential tax treatment of capital gains, this is lower than the marginal tax rate of 50 per cent. But that's a red herring; what matters is that the REIT's 28.125-per-cent tax rate outside the RRSP is higher than the 0-per-cent tax rate inside the RRSP.

The proper way to ask the question is this: If you have $100,000 after tax in a non-registered account and $200,000 in an RRSP (which is equivalent to $100,000 on an after-tax basis) and you must invest one account in the REIT and one in cash, which account should you choose for the REIT? This is a fair question, because the two accounts have the same initial after-tax value.

Let's quickly do the math.

With the REIT in the non-registered account, its value will grow to $111,500 after-tax. Combined with $100,000 net from the RRSP withdrawal, you'll end up with $211,500.

If you hold the REIT in your RRSP instead, it will grow to $232,000 and you'll net $116,000 on withdrawal. Combined with the other $100,000, you'll end up with $216,000.

Conclusion: When you do a fair comparison, holding the REIT in the RRSP wins hands down. Again, it's true of any investment – not just REITs.

If you still believe that some investments – REITs, dividend stocks, whatever – do better outside the RRSP because of the tax breaks they receive, you might as well believe in the Easter bunny.

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