Put Your Assets in Their Place

Couch Potato investors hear a lot about asset allocation, but asset location is also an important consideration. Asset location refers to the type of account you use to hold the stocks, bonds, cash and real estate in your portfolio. It’s important because the growth and income from your investments are treated in different ways by the taxman:

Interest from bond funds and bond ETFs (as well as individual bonds, GICs and money market funds) are taxed at your marginal tax rate, just like employment income.

Dividends from Canadian stocks are eligible for a generous dividend tax credit from the federal government. For the 2009 tax year, eligible dividends are first grossed up (increased) by 45% and declared as income; the investor then receives a tax credit of 19% on the grossed-up amount. Some provinces offer an additional dividend tax credit.

Foreign dividends are taxed at your marginal rate. In addition, many countries (including the US) levy a withholding tax on dividends, often between 10% and 15% (this may be recoverable in non-registered accounts).

Capital gains are profits earned from selling a security for more than you paid for it. You report 50% of your capital gains as income and pay tax on that amount. Mutual funds and ETFs must also pass along their capital gains to unitholders, although index funds are usually more tax-efficient.

Here’s a table highlighting the dramatic differences in how each type of investment income is taxed, assuming a marginal rate of 22%:

Interest Canadian Dividend Capital Gain
Amount received $1,000 $1,000 $1,000
Taxable income $1,000 $1,450 $500
Federal tax (at 22%) $220 $319 $110
Dividend tax credit (19%) -$275.50
Total federal tax owing $220 $43.50 $110

The tax rates above apply to securities held in non-registered investment accounts. Registered accounts offer several opportunities to defer or avoid paying tax on investment growth and income:

  • If your retirement savings are in an RRSP or RRIF, you pay no tax on interest, dividends or capital gains until you withdraw the funds. At that time, you pay tax on the entire withdrawal at your marginal rate. (You can’t claim the dividend tax credit or enjoy the lower tax on capital gains.)
  • With a Registered Education Savings Plan (RESP), you pay no tax until you withdraw the funds. At that time, all the growth is reported as income in your child’s hands. You pay no tax on the amount you put into the account, since contributions were made with after-tax dollars.
  • In a Tax-Free Savings Account (TFSA), all the growth is tax-free, and no tax is payable when the funds are withdrawn.

So, what’s a Couch Potato to do with all this information? If you’re able to hold all your investments in an RRSP or other tax-deferred accounts, you don’t need to worry much about this at all. However, if you also hold ETFs or index funds in a taxable account, review your asset location to make sure you’re not paying more tax than you need to:

Canadian equities deliver their returns from lightly taxed dividends and capital gains. So if you need to hold some of your investments in a taxable account, start with Canadian stocks.

REITs pay generous distributions, but these are not considered dividends. The bulk of the payouts are classified as income and taxed at your full marginal rate. (The rest is usually return of capital.) REITs are therefore best held in a tax-sheltered account.

Bonds (as well as GICs and money market funds) are best held in a tax-sheltered account, since their interest is fully taxable at your marginal rate.

Preferred shares are sometimes considered fixed-income investments, but they pay dividends, not interest. For income-oriented investors who have no more RRSP or TFSA room, Canadian preferred shares may be a good choice in a taxable account because they’re taxed more favourably than bonds.

Canadian-listed ETFs that hold international stocks include the popular iShares XSP and XIN. Although these are traded on the TSX, their underlying holdings are foreign stocks, so the dividends are not eligible for the tax credit. These ETFs are best held in a tax-sheltered account. However, as Canadian Capitalist has pointed out, XSP and XIN (which simply hold US-listed ETFs in a Canadian wrapper) are still subject to the US withholding tax even if they’re held in an RRSP.

Dividends from US-listed ETFs are fully taxable in Canada and get dinged by the additional withholding tax unless you hold the funds in an RRSP. Note that you still pay the withholding tax if the fund is held in an RESP or a TFSA. The good news is that you may be able to recover the withholding tax if you hold them outside an RRSP. A taxable account also allows you to buy and sell ETFs in US dollars and avoid currency exchange fees—most discount brokers do not allow you to hold US dollars in an RRSP. (Questrade and QTrade are the exceptions.)

Pulling all this together, here’s an example of how you might divvy up an ETF portfolio across different accounts with an eye toward keep taxes to a minimum:

Vanguard Total Stock Market (VTI)
Vanguard FTSE Developed Markets (VEA)
Vanguard FTSE Emerging Markets (VWO)
iShares Canadian Universe Bond (XBB)

iShares S&P/TSX Capped REIT (XRE)

Taxable account (assuming no more RRSP or TFSA room)
iShares S&P/TSX Capped Composite (XIC)
iShares S&P/TSX Canadian Preferred Share (CPD)

As you can see, tax planning is complicated, so if you have a large portfolio, consider seeking help from a financial or tax advisor.

159 Responses to Put Your Assets in Their Place

  1. Kelly August 18, 2015 at 5:44 pm #

    Looking at the simple couch potato portfolio with Vanguard ETFs I need some help with “location”.
    Your answer to Mike (feb 7) above is probably the most similar, except I hope to max out my TFSA and RRSP soon so I am planning what is best in non-registered.

    Let’s assume you are using up all your TFSA and RSP and then NEED to locate some investments in unregistered. Also, assume tax rate is higher today than when withdrawing RSP.

    This is what I have figured out. Please help if my logic is wrong.

    VAB: Focus on this in your RSP, (Why? Because bonds have lower growth and future tax expected)
    VXC: Focus on TFSA (Why? Because foreign equities are better in the TFSA)
    VCN: First top-up either RSP or TFSA but only if you have ample room. Put overflow in unregistered. (Why? Can be good in either TFSA or RSP but, there is a Canadian dividend tax credit if unregistered, so it is best to focus on the above two first.)

    What about some of the other Vanguard funds one may want to add to their portfolio?

    VCE: Locate with the same philosophy as VCN?
    VDY: Keep unregistered. (Why? Because there is a Canadian dividend tax credit)
    VRE: I don’t know where this is best or how to prioritise it.

    There are about 10 more but it gets complicated… If someone else has figured out where it is best to put all of these I would be interested in seeing your preferred “location”.


  2. Canadian Couch Potato August 18, 2015 at 10:40 pm #

    @Kelly: There aren’t many hard and fast rules for asset allocation: a lot depends on your specific situation. But in general, Canadian equities are generally the most tax-efficient asset class, so they would likely by your first choice in a non-registered account, not your last. VCE and VCN are largely redundant: no need to hold both. REIT ETFs such as VRE are very tax-inefficient and should generally be held in a registered account or not at all.

  3. RW September 1, 2015 at 9:40 pm #

    Similar to Kelly, I plan to use VAB VCN and VXC across RRSP, TFSA, and unregistered accounts.

    Is it basically VAB in RRSPs, VXC in RRSPs (to avoid US div withholding),and the fill rest of RRSP with VCN with overflow going into TFSA and then unregistered?

    I am still unclear on the US div withholding taxes. If VXC is inside the RRSP can I just forget the withholding and be unaffected and “safe”? The “may be able to recover” outside of rrsp sounds like too much work/hassle if I can avoid it.

    Also, I have never really though about what “short-term” meant since retirement is far away for me. Is 10 yrs too short to be thinking about a etf aggressive portfolio? This would be for the RESP account which is now itself past 50k, but my daughter graduates from high school in 10 yrs and it’s sitting in cash now.

  4. Parin Sunderji September 4, 2015 at 4:18 pm #

    you have VTI as being appropriate to hold in an RRSP account. I believe it is not subject to U.S. withholding tax. However, it is in U.S. $. I am considering investing in VUS which is the Canadian $ equivalent of VTI. Does it enjoy the same exemption from withholding tax as VTI?

  5. Canadian Couch Potato September 4, 2015 at 9:16 pm #

    @Parin: No, VUS does not enjoy the same exemption as VTI. To be exempt from the withholding taxes in an RRSP it must be a US-listed ETF:


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