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:

RRSP
Vanguard Total Stock Market (VTI)
Vanguard Europe Pacific (VEA)
Vanguard Emerging Markets (VWO)
iShares Canadian Universe 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.

124 Responses to Put Your Assets in Their Place

  1. John September 30, 2014 at 10:38 pm #

    @CCP

    Thanks for the response. I’ve thought about it a bit more and read up on what you posted (also this: http://canadiancouchpotato.com/2012/09/17/foreign-withholding-tax-explained/).

    VCN – Non-Reg due to no more room in TFSA after XEF & ZDB
    VUN – Non-Reg due to Foreign Withholding Tax recovery
    XEF – TFSA
    ZDB – Non-Reg

    How does that look? Only other thought is maybe it makes some sense to put a % of VCN in TFSA, wondering if you could shed some light.

    Thanks a lot!

  2. Canadian Couch Potato October 1, 2014 at 9:01 am #

    @John: Based on what you’ve explained this sounds like a reasonable strategy. Not sure what would be gained by putting VCN in the TFSA if it would mean removing some XEF to make room.

  3. John October 1, 2014 at 11:12 am #

    @CCP

    I guess that answers it for me! Thanks for the advice.

  4. Phil H October 1, 2014 at 8:26 pm #

    Hi @CCP

    Just opened my account and I.m about to allocate to my certain accounts. I will not be maxed out in tfsa or rrsp.
    Im confused to what account to put my Canadian etf in. This is what I have so far
    10% cash (TFSA)
    40% Bonds XBB (LIRA from previous job)
    25% Canadian XIU ?? ( do i do taxable if not maxed out)
    10% USA SPY in US$ (RRSP)
    15% International in US$ (RRSP)
    Thanks for your help
    Phil

  5. Canadian Couch Potato October 1, 2014 at 8:57 pm #

    @Phil H: I can’t be too specific without knowing the details of your situation, but this looks generally good. I can’t think of any reason to put Canadian equities in a non-registered account as long as you have TFSA and RRSP room.

  6. Oldie October 1, 2014 at 9:18 pm #

    @CCP: Would it not be a reasonable strategy to put Canadian Equities in a taxable account on a long term basis? My reasoning would be that any positive return would be 1) Increase in value, which is non-taxable until sold, and then only at half marginal rate and 2) Dividends which would be taxed favourably for most Canadians. That would save RRSP and TFSA room for asset classes that are more in need of Canadian tax protection. Actually, I thought that was your underlying reasoning in your advice above to John regarding not shifting VCN from non-registered to TFSA.

  7. Nathan October 1, 2014 at 9:43 pm #

    @Oldie – but in this case Phil mentioned that the TFSA and RRSP are both not maxed out; no point in using a taxable account until they are.

  8. Oldie October 2, 2014 at 1:06 am #

    @Nathan: Right, I was forgetting that for myself the reason I was positioning a significant Canadian Equity investment in my taxable account was that I was actually needing some income now. So extracting some income as Canadian dividends was to me a painless decision. I suppose this might also work for some people in the accumulation phase whose income was low enough that the Canadian dividend was taxed negligibly so that it could be ploughed back into investments. That dollar amount has been taxed already, and will not be taxed when these secondary investments are eventually taken sold, (taxation being only on the eventual capital gain amount on the dividend, and this would be half the marginal rate). That would seem to me to beat keeping it in an RRSP, where dividends are not taxed now, but taxed at the full marginal rate at the time it leaves the RRSP, not to mention that the original investment’s capital gain will also eventually be taxed at the full marginal rate. But of course, I have not taken into account that the RRSP investments are all made with pre-tax dollars; my argument might be more appropriate for one’s TFSA.

  9. Nathan October 2, 2014 at 1:27 am #

    @Oldie: if you need the income, then I could see it for sure. If you’re just plowing distributions back into investments though, a TFSA is always going to be better than taxable. (Unless you end up with a capital loss, but it doesn’t really make sense to optimize for that!) Better to be taxed nothing than even a small amount. Plus, if you eventually run out of TFSA space and decide to move the Canadian equities out, nothing is lost. Your ACB will be whatever amount they’re worth when you move them out, so you only pay taxes on future gains. Plus, any gains earned while in the TFSA have effectively created more TFSA room for other investments.

    The RRSP argument is similar; the fact that you’re effectively investing pre-tax dollars cancels out the fact that funds are taxable on withdrawal.

  10. Sebastien October 2, 2014 at 9:34 am #

    Oldie: Using my Excel workbook, you can find the optimal way to distribute your money between your accounts. It does as you said. RRSP should hold international equity and US equity before Canadian Equity. If there is room left, then you can put Canadian equity in your RRSP. But before any kind of equity, you have to optimize the distribution of fixed income between RRSP and TSFA. The good news is that my Workbook does all the calculation for you. The best split between RRSP and TFSA is calculated so there is the maximum tax-free money in the RRSP.

    Here is the link for my Workbook: https://drive.google.com/file/d/0B6x4qQK9cyjheDNXY29SeEtSS3M/edit?usp=sharing

    The sample datas are based on the post found at: http://www.moneysense.ca/taxes/making-smarter-asset-location-decisions

    You have to download the file to be able to use it. Google Docs misses lot of the new Office 2010+ functions. Please make sure you use Office 2010 or later to open this file. Using Office 2007 or older would cause issue with formulas using specific functions.

    * Check with your advisor to make sure it is right for your situation. I am not responsible for any loss that can happen by using this Workbook.

  11. B October 8, 2014 at 12:34 pm #

    Young investor here – I have maxed out my TFSA, but I’m wondering if I should even bother contributing to my RRSP? As many are pointing out these days, it seems like a good bet that tax rates will be higher at my retirement, and that I may be better off taking the tax hit now.

  12. Canadian Couch Potato October 8, 2014 at 12:46 pm #

    @B: If you’re a long way from retirement, do you really want to bet about what tax rates will be decades in the future? Unless you’re in a very low tax bracket now an RRSP will likely offer you valuable some valuable tax deferral. There’s also an important behavioral benefit to keeping your long-term savings in an RRSP: you’re far less likely to dip into it before retirement.

  13. Paola October 17, 2014 at 2:39 pm #

    Hi. I’m trying to move from mutual funds to some TD e-series and follow the couch potato portfolio approach. My main concern is how to distribute our monies within TDB900, TDB902, TDB911 and TDB909 and be tax efficient. So, which funds are recommended for our TFSA and which for our non-register account?

    Thanks,

  14. Canadian Couch Potato October 17, 2014 at 2:43 pm #

    @Paola: In general, if you need to hold investments in non-registered accounts, Canadian equities are the best choice, followed by US equities, and then international equities. A bond fund like the TD Canadian Bond Index will be very tax-inefficient and is not a good choice in a non-registered account.

  15. Ross November 15, 2014 at 10:58 pm #

    Hi there,

    I recently tried using your asset allocations spreadsheet. The calculator placed TD e-series Canadian Equity and Bonds as well as the International Index in registered accounts but US Equity was split amongst the TFSA and my non-registered account. I was under the impression that order of preference for index funds in taxable accounts is Canadian equities first, then US equities, then International equities? My TFSA contribution room is 43000, RRSP is only 5300 and I am looking to invest 55000 into these accounts.

  16. Sebastien November 15, 2014 at 11:50 pm #

    @Ross: In fact, RRSP and TFSA should be filed first in this order: Fixed income, Real Estate, Canadian Equity, Emerging markets Equity, International Equity, US Equity. Then any remaining money should be put in a taxable account. The order will be like this: US Equity (because you can recover a part of foreign taxes in some cases), International Equity (US foreign taxes could be recovered in some cases), Emerging markets Equity, Canadian Equity. Fixed income should be avoided in a taxable account. GIC should be your preference if you need fixed income in your taxable account. Real estate should not be part of a taxable account at all.

    There is a way to optimize the distribution between RRSP and TSFA for tax efficiency. You better hold the maximum International and US Equity in RRSP as you can recover foreign taxes you could not recover in a TFSA account.

    I am not an expert, but that is what I understood after lot of reading on this site.

  17. Ross November 16, 2014 at 8:17 am #

    @Sebastien: Why exactly should you place Canadian equity in a registered account before international and U.S. equity? Doesn’t that go against what was mentioned in the above article (i.e. 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.)?

  18. Sebastien November 16, 2014 at 9:52 am #

    @Ross: If you invest only in your taxable account, then sure you should invest in Canadian equity first , then US, then International. But if you want to optimize your tax efficiency between RRPS, TFSA and taxable accounts, you should start with non-taxable accounts then put the remaining money for each asset class in your taxable account. You just need to do a simple math to find out how to put in each asset in your taxable account: Money allowance for this asset – Money invested in RRSP – Money invested in TFSA

    If you want to find out how your spreadsheet work, here is the link: http://www.moneysense.ca/taxes/making-smarter-asset-location-decisions

    I made a much more advanced workbook that have all the useful informations I found on this site, MoneySense and some other websites. The hard part is to find out how to split Fixed incomes between RRSP and TFSA to be able to get the most tax efficiency in other assets. My workbook does that work for you! You need a desktop version of Office 2010 or later to use that file. If you try to use it with Google Docs/Drive, Microsoft Office Online or anything else than Microsoft Office 2010, 2011 for Mac or 2013, you’ll have many non-working formulas and functions. Microsoft release some new functions with each desktop versions and even their online version can’t handle all the functionalities. Here is the link, click on the download link when you see the preview: https://drive.google.com/file/d/0B6x4qQK9cyjheDNXY29SeEtSS3M/view?usp=sharing

  19. Canadian Couch Potato November 16, 2014 at 10:46 am #

    @Ross: I’m not sure which asset allocation spreadsheet you’re referring to. Are you sure it was one of mine, or was it Sebastien’s?

    @Sebastien: RE: “If you invest only in your taxable account, then sure you should invest in Canadian equity first , then US, then International. But if you want to optimize your tax efficiency between RRSP, TFSA and taxable accounts, you should start with non-taxable accounts then put the remaining money for each asset class in your taxable account.” Like Ross, I don’t understand this distinction. If you are only investing in a taxable account then your asset location decision is made for you. If you have registered accounts also, then once you run out of room it’s usually best to put Canadian equities in the taxable account first.

    Your spreadsheet is an interesting tool, but I think it’s important to acknowledge that asset location can’t be determined with an algorithm. A lot depends on the individual’s situation, such as where the investor is directing most of their savings and how that might be expected to evolve over time. Your choice of products also matters a lot. I appreciate that many people want to automate these decisions, but believe me, if this were possible then portfolio managers would have already created such a tool to make their lives easier.

  20. Sebastien November 16, 2014 at 11:18 am #

    @Ross: Sorry, I made a big mistake, the order of priority in my workbook (and the one from CCP) for RRSP and TSFA is Fixed Income, International Equity, US Equity then Canadian Equity. So you’re right, in the taxable account, you’ll put money in this order: Canadian Equity, US Equity, International Equity then Fixed Income. I worked on calculations some time ago and noticed my mistake after reading CCP’s reply.

    @CCP: I acknowledge that we can’t find a perfect algorithm for everybody, but my workbook works well for self-investors that use one of your model portfolios or a mix of them. It’s better to have a tool like this when doing investment ourself than none at all. As always, It’s recommended to see with a financial planner or advisor to make sure the decisions are right.

  21. Oldie November 16, 2014 at 3:32 pm #

    I have recently rejigged my finances, and as a recent retiree, I have found it convenient to roll my RRSP into a RRIF which is conservatively invested (I won’t get into this distribution here) and will generate a regular income for the rest of my life that I can split with my wife for taxation purposes, and also qualify me for $2000 annually of pension income tax relief.

    This spares me from requiring ongoing day to day income from my non-registered account (I have additional CPP and OAS income). My TFSA is maxed. I realise I am in a rather unique and fortunate position, but I thought I would share my thinking regarding allocation for those in a similar position, or as a thought experiment for those whose situation is similar enough that that might tweak it to their own purposes.

    I have a taxable portfolio whose funds I don’t need for the foreseeable future. How best to invest? I decided that I could live with a 40/60 Bond/Equities ratio, with the equities split equally to Canadian, US and International. The only complicating issues are with taxation in a taxable portfolio, which admittedly should not be the driving force behind allocation decisions, but which must be considered in context.

    I Initially had invested the bond portion in BXF, whose index held laddered 1-5 year Government strip bonds, to minimise my tax. It was reasonable but not perfect; so when HBB became available this year, after some observation to see how it would track, and to make sure I understood the pricing mechanism, I switched all my bond holding to HBB.

    For the Canadian Equity portion I have left the majority in straight TSE index funds (a mixture of VCE and VCN,(the mixture being a result of tax loss harvesting). I have a small percentage in FXM which represents an attempt to diversify in the direction of splitting into some small cap-value. I am guilty here of deviating from the plain vanilla Couch Potato Plan, but my reasoning was that from a tax viewpoint, at least, the favourable dividend and capital gains effect was the same as the rest of the Canadian Equity.

    For my US Equity, not wanting to have to deal with any foreign dividend income which would be taxed as full income, I bought HXS, which transforms any dividend income into share price increase by using a “total return swap.” The increased management fee was offset, I felt by the Canadian tax savings I would realise in the years to come, and the fact that no US dividends and thus no US withholding tax would be generated. I also had a small percentage invested directly in US dollars in a small cap value ETF VBR — I figured I could live with the small absolute amount of dividend that would be subjected to Canadian tax, and the US withholding tax would be credited by the CRA to me, I hope.

    The remaining one third of Equity allocated to international markets I further split into 2 thirds ZEA and 1 third XEC. No fancy tax avoidance here — I will just pay full tax on any foreign dividend that I get.

    The one remaining tweak that I have been considering for a while is whether or not to convert some or all of my Canadian equities to HXT. The cost is as low as with the current allocation, but all return now represented by dividend would be transformed into price appreciation. I am struggling with the math here, but currently it seems to me that the low tax I am currently paying on Canadian dividend is worth it compared to the capital gain tax I would otherwise pay, admittedly deferred for many years.

    I should note that all these funds have been fully described and discussed in the Couch Potato pages over the years (except for VBR which has been mentioned as a component of the Uber-Tuber portfolio). I must warn all reading this that I consider myself a novice, and may not necessarily have exercised the best judgement in coming to these choices. My disclosure is meant to generate thought and discussion, not to be construed as advice. I accept any responsibility in advance for possibly misinterpreting or misunderstanding what might have been properly explained by the Canadian Couch Potato.

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