When you’re earning interest on your investments, you’re going to have to pay tax on the income if they’re sitting in a non-registered account. But if they’re held in a registered account—such as an RRSP—you can earn interest without having to pay tax.
Interest is taxable and taxed at a higher rate than capital gains. That’s one of the main reasons why you should hold GICs and other fixed-income products in an RRSP or any other registered account.
Want a better GIC rate?
Let’s assume you put $10,000 into a one-year GIC with a rate of 3.1% in a non-registered account. We’ll also assume you live in Ontario and you make $80,000 a year, which means your marginal tax rate is 31.48%.
After one year, you’ll earn $310 in interest. However, that interest is taxable. You’ll need to pay $97.59 in tax, leaving you with just $212.41 after tax.
If you hold stocks, mutual funds, or exchange-traded funds in a non-registered account, they’re taxed more favourably than investments that pay interest.
For example, let’s assume you put $10,000 into ABC Company shares. You sell those shares a year later for $10,310, which is equal to a rate of return of 3.1%. We’ll assume your marginal tax rate is the same as the example above. Capital gains, however, are taxed at half the rate as interest. That means if your marginal tax rate is 31.48%, the rate you pay on capital gains is half that amount or 15.74%.
After one year, you’ll earn a capital gain of $310. While the gain is still taxable, it’s at a much lower rate than interest. You’ll need to pay $48.79 in tax, leaving you with $261.21 after tax.
As you can see, you don’t have to pay as much tax on an investment that produces a capital gain, leaving you with more money after tax compared to an investment that pays interest.
However, you can avoid having to pay tax on income from your GICs if you hold them in an RRSP. If you earn $310 in interest on $10,000, you don’t have to pay any tax until you begin withdrawing money from your RRSP, which will hopefully be when you’re retired and in a much lower tax bracket.
If you’re planning to buy a home in the near future and are going to participate in the Home Buyers’ Plan, it’s better to hold GICs in an RRSP because they’re safe and you won’t lose money. Buying stocks to save for a home is very risky since there’s a chance you could lose money.
Also, GICs will help diversify an investment portfolio. Having fixed-income products (such as bonds and GICs) can reduce volatility when you hold equity investments (stocks, mutual funds, and exchange-traded funds) in your portfolio.
The bottom line
Holding GICs in an RRSP or other registered account is a great way to avoid paying tax on the interest you earn. However, you don’t want to hold just GICs in your retirement savings portfolio. You should have a mixture of different types of investments based on the amount of risk you’re willing to take and the lifestyle you want to live in retirement.