Asset Location: Which Investments in Which Accounts
Do you mean asset allocation?
If you have read anything about setting up an investment portfolio, you have probably come across the term asset allocation. This term has to do with how you mix the various investment options at your disposal. For example, if you scan through the standard categories for investment funds in Canada, you will come across categories like Canadian Dividend & Income Equity, Canadian Equity, Canadian Fixed Income, Canadian Money Market, Canadian Small/Mid Cap Equity, and that’s just a few of the categories that begin with the word Canadian. Getting that mix among the various categories, choosing some categories over others, and weighting them according to your ability, need, and willingness to take risk, that “allocation,” is the key driver to long-term investment success according to portfolio theory. I like the way Steadyhand Investment Funds refers to it: your Strategic Asset Mix or “SAM.”
Asset location is something else
In Canada, we retail investors have three basic account types to choose from: the Registered Retirement Savings Plan (RRSP), the Tax-Free Savings Account (TFSA), and a non-registered account. The existence of these three different account types, with their different taxation regimes, means that it can make sense to use particular account types for particular investments.
This is a tax issue
U.S.-domiciled stocks or ETFs
For example, if you buy a U.S.-domiciled ETF, it is going to be treated differently for tax purposes, depending on the account type in which it is held. Let’s choose VTI for our example. VTI is an ETF issued by Vanguard in the United States. It is, however, quite a popular ETF in Canada as well, since with one purchase you give your account exposure to about 4,000 different U.S. stocks. Although not usually purchased for its distributions, since it only yields about 1.25% currently, let’s consider the tax treatment of the distributions (dividends) that VTI pays four times a year. For this comparison, I will assume that you have U.S. currency accounts in each of the account types so that foreign exchange is not an issue.
In an RRSP
Thanks to a tax treaty between the United States and Canada, if you hold a U.S.-domiciled stock or ETF inside an RRSP, there is no taxation of the dividends. The IRS recognizes the RRSP as a retirement account and does not withhold tax. If in the year, your holdings in VTI generate $1,000 in dividends, you will not pay any tax. You will receive the entire $1,000.
In a non-registered account
Non-registered accounts are not specifically for retirement purposes, so there is no treaty preventing the IRS from claiming the withholding tax, which is 15%. You may be owed $1,000 in dividends from VTI, but you will have only received $850 since $150 will have been withheld. Fortunately, you can claim a foreign tax credit on your annual return, which will effectively reduce the impact of that withholding tax.
In a TFSA
Unlike the RRSP, the TFSA is not recognized as a retirement account by the IRS, which is fair, I think, regardless of whether you use it for retirement savings. For that reason, you will find that of your $1,000 in dividends, 15% or $150, will be deducted as withholding tax. However, unlike with the non-registered account, since tax on any income is not payable to the Canada Revenue Agency, there is no compensation available through the foreign tax credit.
Given these three options, it seems reasonable, then, to hold your U.S.-domiciled equity investments in your RRSP first and your non-registered accounts second, especially if dividends are your focus.
Canadian interest income
Interest income is taxed at the same rate as ordinary income. There is no tax advantage as you might find with Canadian dividend-paying securities, which have a gross-up and tax credit system, or with capital gains, which only require investors to include 50% of the gain for tax purposes.
In an RRSP
Eventually, you will have to convert your RRSP account from a savings vehicle to an income vehicle. This is commonly done by converting your RRSP to a RRIF (Registered Retirement Income Fund). When money is withdrawn from a RRIF, you pay tax at your regular tax rates. If your income is such that your next dollar of income is taxed at a rate of 30%, then a $1,000 withdrawal from your RRIF, will net you $700 after tax. It doesn’t matter whether that $1,000 in income came from capital gains, dividend payments, or interest payments. Since the money passed over the threshold from inside the RRIF to outside the RRIF, it is fully taxable.
In a non-registered account
If you receive interest payments totalling $1,000 from a bond, GIC, or savings account, you are going to be taxed on it in the year in which it was paid to you. That is one difference that a RRIF has over a non-registered account; if you generate more income than you need to withdraw from your RRIF, then you don’t need to pay tax on the amount of interest income that remains inside the RRIF. Not so with the non-registered account, because there are no tax-deferral opportunities available on interest income.
In a TFSA
Interest income earned inside a TFSA is not taxed. It is a tax-free account. This is why it is touted by the banks as a wonderful place to keep your interest-bearing savings; you don’t get much in the way of interest, but at least it’s not taxed.
Ostensibly, this would make the TFSA the best account in which to hold interest-bearing investment assets, as they would never be taxed. The RRSP/RRIF would be the next best account because the money coming out of that account is always going to be taxed at the same level as interest income regardless of its source. The RRSP/RRIF is also superior to the non-registered account because like all income inside the RRSP, the tax is deferred until it is withdrawn. The non-registered account is apparently the least beneficial account in which to hold interest-bearing investments.
In an RRSP
As noted above, tax on income within an RRSP, regardless of its source, is deferred until it is withdrawn. When it is withdrawn, however, the income is treated the same, so the tax-advantaged nature of Canadian dividend income is lost.
In a non-registered account
Compared to interest income, dividend income is advantageous on an after-tax basis. First, however, note that, unlike in an RRSP, where the taxes can be deferred, or a TFSA, where no tax is applicable, in a non-registered account you will need to pay tax on the dividends in the year in which the dividends are received. However, thanks to the dividend tax credit, you may pay little tax at all. Indeed, in some circumstances, the tax credit may even lead to a credit greater than the tax.
In a TFSA
As with other income-generating assets inside a TFSA, eligible Canadian dividend income is paid to you without any tax implications.
Given the possibility that the dividend tax credit may be so beneficial that you might pay no tax at all and possibly receive a tax credit large enough to offset taxes from other sources, it is understandable that the many fans of dividend investing in Canada advocate for putting Canadian dividend-paying stocks or ETFs into non-registered accounts. This situation does not always apply, however, so it seems equally reasonable to put this type of investment into a TFSA. Perhaps the least likely place to put Canadian dividend-paying securities is the RRSP, although there again, there is a benefit to being able to defer tax on the dividend income, allowing it to compound over the years until the income needs to be withdrawn when the RRSP is converted into a RRIF.
Capital Gains and Losses
In an RRSP
Recognizing once again that all withdrawals are taxed the same, the benefit of generating capital gains inside an RRSP is that there is no taxation while it remains in the account. If you need to rebalance your assets inside your RRSP, for example, when one asset has grown to take up a much larger percentage of your portfolio than you want, at least you don’t have to worry about being taxed on the withdrawals. On the other hand, if you decide to sell a losing position and generate a capital loss, you cannot use that loss to offset current-year or future taxes.
In a non-registered account
Capital gains are taxed in the year that the gain occurs; there is no deferral. However, capital gains are taxed at a 50% inclusion rate, meaning that a $1,000 gain is taxed as though the gain had only been $500. Furthermore, if there are capital losses because you sold an investment for less than its adjusted cost base (ACB), then you can claim the loss to offset capital gains, going back three tax years if you want, using it in the current tax year, or carrying it forward indefinitely to offset capital gains in the future.
In a TFSA
As with other forms of income, there is no tax on capital gains. However, if you sell a losing position, capital losses cannot be used to offset gains.
Is there a clear best choice here among the three account types? The ability to use capital losses to offset capital gains is, in a way, built into the tax-deferred nature of the RRSP or the tax-free nature of the TFSA. Nobody invests in an asset thinking that they are going to lose money on the venture. However, some assets are more speculative than others. Small mining exploration companies may not make any money at all. Putting those in a non-registered account might be the right choice to make given the higher potential for loss. However, putting more stable companies, businesses that are more likely to earn a profit and grow in value into an RRSP or TFSA, is probably a better choice.
Can you comfortably manage asset location?
If you are a DIY investor who is seeking every last edge, then it may be worth your while to put interest-generating assets like bonds, bond mutual funds, or bond ETFs, as well as any U.S.-domiciled equity securities, into your RRSP. You would probably choose to put your Canadian equities into either your TFSA or non-registered account. But keeping those assets balanced is not so easily done. It’s one thing to manage the assets in one account, but if you have to manage it across three different accounts with three different patterns of taxation, it can become quite complex.
This is still a tax issue
The problem is that this is still a tax issue. Let’s say you have $100,000 spread across your TFSA and your RRSP. You have room in both accounts such that you do not even need to open a non-registered account. You have settled on a 60% equity / 40% fixed income portfolio. You decide to put $40,000 in fixed income into your RRSP. You then put the balance, $60,000 into equities in your TFSA. A year later, you look at your accounts and see that your TFSA has grown in value by 10%, while the value of the fixed income in your RRSP has grown by 3%. The new balances are $66,000 in your TFSA and $41,200 in your RRSP, for a new total of $107,200.
Since it is a new year, you contribute $6,000, the current contribution limit, into your TFSA for a new balance in that account of $72,000. How much should you put into your RRSP, though? If $72,000 is supposed to be 60% of your portfolio, then your total portfolio should be $120,000, meaning the RRSP needs to hold $48,000 in fixed income assets. You need to add $6,800 to your RRSP to get the balance where it needs to be. Fortunately, you have the contribution room and the available cash, so you make the contribution and add to your fixed-income position.
You repeat this annually but find that sometimes you do not have the contribution room in your RRSP to achieve the proper balance between equities and fixed income, between your TFSA and your RRSP. Eventually, your balance drifts from 60/40 to 75/25.
At retirement, your TFSA has reached a healthy $750,000, all in equities, while your RRSP has a value of $250,000, all in fixed income. You figure that you will continue with your 75/25 ratio in withdrawals, too. In your first year, you figure that you can withdraw 5% of your portfolio. Five percent of $250,000 is $12,500 from your RRSP, now converted to a RRIF.
But there is tax involved. Or at least there is on the RRIF. $12,500 is the Annual Minimum Payment for that first year, so you are not obligated to have tax withheld at the time of the withdrawal, fortunately. At a 25% tax rate, though, you need to pay $4,167 in taxes to get $12,500. On the TFSA side, there is no tax at all. So, to keep the balance, you withdraw $37,500 from your TFSA. $750,000 less $37,500 equals $712,500. Oh, but you need to cover the tax. So, you take out an extra $4,167, which reduces the TFSA to $708,333. After the withdrawals, the new balances are $708,333 / $237,500. This is not a huge discrepancy by any means, but the ratio does change to 74.89 / 25.11.
What’s your point… Russell?
I have two points, actually, First, while employing asset location as a way to incrementally improve your returns can be done, it can quickly become complicated. It can cause you to deviate from your asset allocation, causing you to drift away from your intended portfolio.
Second, while this is less of an issue when the two account types are RRSP and TFSA, when a non-registered account is introduced, putting slow-growing fixed-income assets into your tax-sheltered accounts while forcing your assets with higher growth potential to go into the taxable non-registered account can lead to a loss of a tax-deferred growth opportunity for your equity investments. Would you not prefer to defer (RRSP/RRIF) or avoid (TFSA) tax on the assets with the higher growth potential?
For these reasons, I am inclined to encourage DIY investors to employ the same asset allocation across all account types.
This is the 119th blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.