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, if you hold US-listed ETFs, the Internal Revenue Service will take a 15% withholding tax on all dividends unless the funds are held in an RRSP.
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%:
|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- In a Tax-Free Savings Account (TFSA), all the growth is tax-free, and no tax is payable when the funds are withdrawn.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.
Income trusts, like REITs, pay most of their distributions as income. However, beginning in 2011, when trusts must convert to corporations, their distributions will start being classified as dividends and will therefore be eligible for the tax credit. For now, hold them in a tax-sheltered account if you can.
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 15% 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 Europe Pacific (VEA)
Vanguard Emerging Markets (VWO)
iShares Canadian Bond (XBB)
iShares Canadian REIT Sector (XRE)
Cash (GICs or money market fund)
Taxable account (assuming no more RRSP or TFSA room)
iShares Canadian Composite (XIC)
Claymore S&P/TSX 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.