After having coffee with Brian Undershute, an advisor friend of mine, he shared with me a case he was working on late last year about swapping investments. I thought I would share this scenario because it’s a great example of being tax smart with your investments and how tax efficiency can help during times where the markets do not seem to be as safe and rewarding place to be.

Joe, the client, is 52 and has 8 years to retirement. He has $250,000 in his RRSPs in a portfolio of mutual funds with a mix if about 70% equities and 30% fixed income. A few years back, he put some non-RRSP money into a Mortgage Investment Corporation (a portfolio of first and second mortgages) through a company called Carevest for diversification purposes. Like many investors, he was not happy with the returns from his mutual funds and the stock market and wanted something more conservative. Although the returns have been decent in his Carevest investments (an average of about 8% per year), he is paying 36% tax on the income because it is interest income. His after tax return on the mortgage portfolio is about 5.1%

The problem with Joe’s investments is something I call tax efficiency. He is holding all of his interest bearing investments outside of the RRSP and paying full tax on the interest income. Inside the RRSP, he is holding equities, which is generating capital gains and dividends. Here’s where the swap makes sense.

His advisor, Brian, has helped Joe to start the process of swapping the non-RRSP investments for the RRSP investments. In other words, the swap is the process of moving the Carevest investment into the RRSP and moving the mutual funds outside the RRSP without any tax implications. There is an administrative process to make this happen and it has to be done right to avoid a large tax bill at the end of the year.

The steps to the process are a little complicated because Carevest does not sell products other than their own. At the same time, Brian, the advisor cannot sell the Carevest product so both Brian and Carevest have to work together to make the swap happen properly. The first step was for Brian and Joe to sit down with Carevest to outline the process of the swap.

Next, Carevest completed the paperwork to open up a RRSP account and transfer the $250,000 RRSP account of RRSP mutual funds into a the same Carevest Mortgage Investment Corporation. This transfer typically takes 3 to 6 weeks to move money from one institution to another.

While the RRSP transfer is happening, Joe, liquidated $250,000 of the Carevest investment he held outside the RRSP into cash. This took about 7 days. Once this money was liquidated, Brian went through the process of purchasing a similar portfolio of ‘tax efficient’ mutual funds including some corporate class funds (outside the RRSP).

The end result

At the end of the swapping process, Joe had the same investments but organized in a more tax efficient manor. Joe, now has the mortgage portfolio inside the RRSP where he will continue to compound the interest returns tax sheltered. If we assume he continues to make 8% with this portfolio of mortgages (although there is no guarantee of returns), he will no longer have a big tax bill every year and the RRSPs will compound nicely. At the same time, the $250,000 portfolio of mutual funds is now outside the RRSP and will be much more tax efficient because capital gains and dividend income is tax preferred over interest income.

Also, when markets go through corrections or periods of volatility, any losses can potentially be written off against capital gains. Then the equities were inside the RRSP, nothing could be done with the losses. Although the goal is not to lose money, the reality is there will be times in the market where losses will occur. Tax losses can be a tax strategy that is helpful when markets or investments do not work in your favour.

The good and the bad

I have always preached the merits of tax efficiency and being tax smart, so I think it makes lots of sense to keep tax efficient income like dividends and capital gains outside the RRSP and less efficient investment income like interest inside the RRSP.

In terms of this swap, there could be some issues or concerns to be aware of:

• Through the administration process, there may be some time where you may be ‘out of the markets’ or not fully invested. There could be a timing risk where markets jump up while the transfer or swap is occurring. In the big picture, the week or two that you could be out of the markets is probably a fairly small risk but the risk is there.
• Before a swap like this happens, it is important to make sure you are aware of any transfer fees, purchase fees, back end loads or penalties for selling or buying. In Joe’s case, all his mutual funds were no load so there was no fees to liquidate the mutual fund portfolio. There was a $75 charge from the trustee of the RRSP to transfer the money and close the RRSP account but that was small enough to justify the benefits.
• Many years ago, I ran across a similar scenario and although there were no fees to liquidate the $250,000 RRSP of mutual funds, when the advisor went to purchase the new funds outside the RRSP, he purchased new back end load funds which generated $10,000 in up front commissions and locked the client in for a period of 6 to 8 years. The client was not aware this happened until a few years later when he tried to take some of the money out to buy a property. Make sure that when you buy the new investments, you are in a similar or better position than before you swapped.
• It is also important to check to see if there is any tax liabilities with the investment outside the RRSP. In the example above, the investment is a pool of fixed income so there was no tax triggered at the time of the swap because the tax on interest was paid yearly.
• Make sure all parties and institutions are aware of what you are trying to accomplish. In this example, it was imperative that Carevest, the RRSP trustee, Joe and the advisor were all on the same page. The last thing anyone wanted was for Joe, to de-register the RRSPs and now have a $100,000 tax bill.