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 is 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 must also pass along their capital gains to unitholders, although index funds (and especially ETFs) rarely do so.
Here’s a table highlighting the dramatic differences in how each type of investment income is taxed, assuming a marginal rate of 22%:
| Canadian | Capital | ||
| Interest | Dividend | 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.
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 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 are 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:
RRSP
Vanguard Total Stock Market (VTI)
Vanguard Europe Pacific (VEA)
Vanguard Emerging Markets (VWO)
iShares Canadian Bond (XBB)
TFSA
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.
{ 12 comments… read them below or add one }
Thanks for this clarification; it has prompted me to move some funds around that will help in my taxes.
Nothing big, but it’s free money if I just do the manouver!
Hi, thanks for this piece. The question of how to optimally organize a portfolio across the various types of accounts that are available to Canadian investors is an important one and often gets ignored. Two questions:
Am I correct in understanding, then, that the distributions from my USD-denominated ETFs (e.g. VTI) will NOT get hit with the witholding tax as long as I hold them in my RSP?
Also, are you saying that investors can recover the US witholding tax on USD denominated securities if they’re held in TFSA or non-registered accounts, it’s just that paperwork is involved?
I hold VTI, VEA and VWO and recent gains in these positions have been erased by the run up in the Canadian dollar. About a year ago I had to decide how to play the US market and i chose VTI over XSP. I would have been way ahead if I’d chosen XSP. However, it’s the long term that I care about. Pretty much impossible to forecast where the CAD dollar will be relative to the USD in 25 years!
> Am I correct in understanding, then, that the distributions from my USD-denominated ETFs (e.g. VTI) will NOT get hit with the withholding tax as long as I hold them in my RSP?
You are correct. Canada and the US have a tax treaty that eliminates the withholding tax in accounts that are designated as “retirement savings.” RRSPs and RRIFs are covered, but TFSAs are not.
> Also, are you saying that investors can recover the US withholding tax on USD denominated securities if they’re held in TFSA or non-registered accounts, it’s just that paperwork is involved?
You may be able to recover it in a taxable account, but not in a TFSA (see Erick’s post below). I have to confess I have not personally had cause to do this, so I don’t know all the details. If you have significant US holdings outside your RRSP, you should ask an accountant or tax preparer about this. The amount invested would have to be significant to make this worthwhile: with US stocks paying about a 2% yield these days, the withholding tax amounts to about $30 annually for every $10,000 invested. So you can think of the withholding tax as an extra cost of 0.30%.
> Pretty much impossible to forecast where the CAD dollar will be relative to the USD in 25 years!
Absolutely. You can’t judge the success of currency hedging by what happens in a year. VTI is much less expensive than XSP, so over the very long term, assuming currency fluctuations even out, it’s likely to be the better choice.
CCP: Where would US listed Dividend ETF’s be more tax efficient: TFSA or RRSP?
Thanks for the excellent summary.
We have just pulled all our of savings out of a big bank wrap account and are transferring it to a discount broker.We’ve been giving a lot of thought to asset allocations as we basically have multiple registered accounts and a non registered in cash waiting to be invested. This post (in fact, all your posts) has been a great help.
Hey there,
Just a point of clarification on this question:
“Also, are you saying that investors can recover the US withholding tax on USD denominated securities if they’re held in TFSA or non-registered accounts, it’s just that paperwork is involved?”
If you own a U.S. dividends paying stock inside a TFSA, the withholding tax applies and you cannot claim it as a foreign tax credit or deduction on your tax return.
For non-registered accounts, you report the amount withheld when you do your taxes:
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns409-485/405-eng.html
Erick: Many thanks for clarifying this. I’ve updated the post accordingly.
As Erick points out above, TFSAs are still subject to the withholding tax, so an RRSP would be more tax efficient for US-listed dividend ETFs.
Question: this post sort of assumes all your savings are targeted towards the same goal (retirement, mostly). Does that mean your asset allocation is calculated irrespective of whether the money is in a registered account or not?
I’ve been assuming that (as a younger person) the retirement money is in the RRSP, and is fairly aggressive (long-term). Money outside the RRSP is for things like downpayments on houses, and so is less aggressive.
This means that I essentially treat each goal as a separate pot of funds, with individual asset allocation targets. Consequently, I hold some assets – like bonds – outside of my RRSP accounts. My assumption is the asset allocation offsets the tax penalties.
Should I instead treat all my savings the same, and just dip into the appropriate account as needed? This implies that the less-liquid RRSP holds the less risky investments. The problem, of course is that if I need some money for a purchase, I may have to sell some stocks at a poor time to get it.
Neil: Great questions. The post did indeed assume that all of your investments were for the same long-term purpose.
As you recognize, the key point here is that your decisions about asset allocation and location depend on what you’re going to use the money for. If you have different goals (e.g. saving for retirement and saving a down payment) then you have to think of those independently.
Even if you’re saving for a home inside your RRSP (through the Home Buyer’s Plan), you’ll likely want to earmark part of your savings for each goal and adjust the allocation accordingly. For example, a young person might hold all his retirement savings in stocks (for now), plus another portion in a money market fund for a down payment, all in a single RRSP account.
Bottom line, it sounds like you’re doing everything right.
Great article! I only wish my ‘certified financial planner’ knew half of this when he was constructing our portfolio of mutual funds over the past 20 years. Somehow he got our Canadian equity funds in our RRSPs and our foreign funds mostly in our ‘non-deferred’ account. No amount of questions during our ‘reviews’ about tax efficiency got a straight answer yet year after year, we got those slips in the mail at tax time. After all, he was a ‘certified financial planner’. Who would know better?
I hope that others reading this, even if they don’t use your couch potato strategies, will not make the same mistakes as we have and we made a lot of them. Educate yourself, even if it is just enough to know what to look for, what questions to ask and to know a ‘brush off’ when you hear it. This article is gold and very timely.
Keep up the great work!
@Doug: Thanks, and glad you found it useful. I’m surprised that a CFP would not have known this stuff. It’s covered in their training. Sometimes I think people would be better off managing their own investments and just paying an accountant for a few hours of advice each year.
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