Do Bonds Still Belong in an RRSP?

It has long been conventional wisdom that bonds should be held in RRSPs wherever possible, since interest income is fully taxable. Once you run out of contribution room, equities can go in a non-registered account, because Canadian dividends and capital gains are taxed more favorably. But is this idea still valid? That’s the question Justin Bender and I explore in our new white paper, Asset Location for Taxable Investors.

Here’s an example we used to illustrate the problem. Assume you’re an Ontario investor with a marginal tax rate of 46.41%. Your non-registered account holds $1,000 in Canadian equities that return 8%, of which 3% is from eligible dividends and 5% is a realized capital gain. You would pay $8.86 in tax on the dividend income ($30 x 29.52%) and $11.60 on the realized capital gain ($50 x 23.20%), for a total of $20.46. Meanwhile, a $1,000 bond yielding 5% (or $50 annually) would be taxed at your full marginal rate, resulting in a tax bill of $23.21.

In this example, even though the total return on the stocks was higher (8% versus 5%) the amount of tax payable on the bond holding was significantly greater. If you had only $1,000 of RRSP room and you wanted to maximize your tax deferral, it would have been preferable to keep the bonds in the RRSP and the equities in a taxable account.

But while you could get 5% on bonds a decade ago, the current yield on 10-year Government of Canada bonds is about half that today. To return to our example, if the $1,000 bond yielded 2.5% it would generate $25 in annual interest, resulting in a tax bill of just $11.25. In that case, you would enjoy greater tax deferral by holding the equities in your RRSP. Does that mean the old asset location rules no longer apply?

Using real numbers

Let’s start by admitting the optimal asset location can only be known in retrospect. We can make assumptions about stock returns and bond yields, but these change over the years. The amount of tax you ultimately pay also depends on when you decide to realize capital gains. So it’s not possible to do an analysis that produces a definitive answer. However, Justin and I wanted to use some real historical returns rather than relying on assumptions.

The full methodology is described in the white paper, but here’s a summary. We assumed an investor started with $1 million in 2003, and that half this money was in a bond ETF and the other half was divided equally between Canadian, US and international equity ETFs. In Portfolio A, the bonds were held in an RRSP and the equities were held in a taxable account. In Portfolio B, that was reversed. We assumed no money was added or withdrawn for 10 years, but both portfolios were rebalanced annually.

Our analysis found that Portfolio A would have returned 4.96% annualized from 2003 through 2012, while Portfolio B returned 4.60%. The decision to put bonds in the RRSP therefore added 0.36% annually. If we assume all the deferred capital gains in the taxable account were realized at the end of 2012, Portfolio A still outperformed by 0.30% annually.

What about the coming decade?

While it would have been preferable to hold bonds in an RRSP during the last decade, we can’t draw any sweeping conclusions from our findings. Bond yields are much lower today than they were in 2003, and the situation might have changed. Going forward, is holding bonds in an RRSP still the right asset location strategy?

Again, no one can know this in advance. But investors need to make a decision, and we believe it still makes sense to follow the conventional wisdom and keep bonds in an RRSP and equities (when necessary) in a taxable account. The discussion section at the end of the paper explains our reasoning in detail, but here are the main arguments:

  • Deferred capital gains on equities can be realized at a lower tax rate. In our analysis, we assumed the investor realized all capital gains at the end of the 10-year period and paid taxes at 23.20%. In real life an investor with significant capital gains from equities would be able realize them gradually in retirement, likely at a lower rate.
  • Lower mandatory RRIF withdrawals. If holding high-growth stocks in an RRSP defers more taxes today, the investor would also end up retiring with a larger registered account. Minimum RRIF withdrawals would therefore be higher, which could result in significantly larger tax bills during retirement and potentially a clawback of Old Age Security benefits.
  • Premium bonds are particularly tax-inefficient. The period we examined would actually have been a relatively good time to hold bonds in a non-registered account. Bond ETFs today are far more likely to hold premium bonds, which are exceptionally tax-inefficient and should generally not be held in non-registered accounts.
  • New contributions would reduce capital gains. Our analysis assumed no new contributions to the portfolio. In reality, investors in the accumulation phase regularly add to their accounts, and this new cash could be used to top up underweight asset classes. That would reduce the need to sell assets when rebalancing, thereby reducing realized capital gains.
  • Tax loss selling can further defer capital gains. A disciplined tax loss selling strategy (which we did not include in our analysis) would likely have deferred at least a portion of the capital gains on the equity ETFs in the taxable account. Opportunities for tax loss selling with bond ETFs are limited.
  • Foreign withholding taxes may be lost in an RRSP. If you hold US and international equities through Canadian-listed ETFs, you face an additional drag from foreign withholding taxes on dividends. You can reduce or avoid these in an RRSP by using US-listed ETFs, but the cost of converting your Canadian dollars to US dollars can be high.

26 Responses to Do Bonds Still Belong in an RRSP?

  1. ccpfan April 24, 2014 at 2:58 pm #

    Dan, what is your stand on Rick Ferri’s behavioral observation regarding asset location:

    “… Second, there is a hidden risk with having different allocations in taxable versus non-taxable, and we saw this risk turn into reality during 2008 and early 2009. A few clients terminated their higher risk taxable portfolio because that specific portfolio was losing more money than the more conservative non-taxable portfolio. In other words, they separated their portfolios in their mind and compared returns rather than looking at the big picture. …” ( http://www.bogleheads.org/forum/viewtopic.php?f=1&t=98662#p1426569 )

  2. Canadian Couch Potato April 24, 2014 at 4:07 pm #

    @ccpfan: That’s an interesting observation. It’s true that many people do seem to look at their returns on an account-specific basis, which makes no sense if all your accounts are earmarked for the same goal. But to me the solution is to get people to understand this problem rather than to just assume it will arise at the first sign of trouble.

    I think this argument is a lot stronger for a DIY investor. If you’re a portfolio manager, using the same asset mix in every account just seems a bit lazy. It’s certainly more work to use thoughtful asset location, but it should be part of the value you provide as an advisor.

  3. ccpfan April 24, 2014 at 4:27 pm #

    Thanks.

  4. HarveyM April 24, 2014 at 10:33 pm #

    Asset allocation mirroring among separate accounts for me as a DIY investor is simpler when it comes to rebalancing as the biggest advantage. It also mitigates the above issue of comparing returns among accounts. This simplicity comes at a cost of some tax inefficiency however. But my own experience with investment advisors is that many defer tax implications to accountants who generally are too busy to help. I think PWL is a rarity in providing a most complete service.

  5. ST April 24, 2014 at 11:32 pm #

    Dan, I was wondering what the results would be if you used expected returns (http://canadiancouchpotato.com/2013/02/25/estimating-future-stock-returns/) rather than past returns.

    Also, given that dividends on US and international stocks are taxed at the same rate as interest from bonds shouldn’t one put US and international stocks in an RRSP before bonds?

  6. Andrew April 25, 2014 at 10:04 am #

    Fantastic post packed with useful information. This kind of info is generally so useful and I would echo Harvey Ms comment. So often the advisor cannot answer the specific important questions about tax that impact asset allocation and withdrawal implications with RIFs for example. I know a senior who had very bad advice in this regard and another whose advisor gives that pat answer “Consult your accountant” which is crazy bad service given how much she pays in fees.

    I am interested in the analysis of the comment of @ST about projected return assumptions.

  7. Canadian Couch Potato April 25, 2014 at 10:26 am #

    @HarveyM and Andrew: Glad you found this useful. I agree it’s a cop out for an advisor to deflect all tax questions to an accountant. Accountants don’t necessarily know how a client’s assets are invested, nor do they all understand the subtleties of how investments are taxed.

    @ST: I really don’t see any value in running the numbers again using expected returns. That has already been done in various ways before, and that’s specifically why we wanted to use historical returns from actual ETFs in our paper.

  8. Simon S April 25, 2014 at 10:43 am #

    Hi Dan,

    In most of your discussions on tax strategy, you talk about either tax sheltered accounts in general, or RRSPs specifically. Should we assume in the discussion and analysis above that TFSAs would behave more or less identically to RRSPs as far as how they shelter various asset classes from tax? Or will they shelter some classes differently from how an RRSP would do?

    I’m thinking specifically of foreign whitholding taxes, which you generally say are lost in an RRSP. I gather in a non-registered account, they’re still charged but you can go through a process to retrieve them after the fact – is that correct? Anyway, is the same true of TFSAs?

    I notice you’ve written a bit about this here:

    http://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/

    but I’m wondering if there’s a quick takeaway as to how that previous discussion applies to this one, re: TFSAs.

    Thanks.

  9. Canadian Couch Potato April 25, 2014 at 10:50 am #

    @Simon S: TFSAs complicate things a bit. We left them out of the white paper because A) they did not exist for the whole period we looked at, and B) because they are currently very small relative to the overall portfolio of anyone for whom asset location is a significant issue.

    To answer your questions about foreign withholding taxes: they are actually more of an issue in a TFSA because there is no way to be exempted. With an RRSP, holding US-listed ETFs allows you to avoid the tax. And yes, with a non-registered account you would pay them, but you can claim an offsetting foreign tax credit on your return.

  10. Stephen April 25, 2014 at 12:36 pm #

    Hi Dan.

    Firstly, thanks for your terrific work and website. I recall an earlier post by you that said that, if you have investments in both registered and non-registered accounts, you should consider all such accounts as one overall portfolio for purposes of creating your asset allocation mix (between equities and bonds, etc.). However, since the monies in registered accounts are subject to tax upon their withdrawal, would you discount the value of the investments in your registered account by a certain percentage to account for this, when you want to re-balance your overall portfolio to ensure, for example, that your overall asset allocation is 60% equities and 40% bonds? In other words, $10 in an RRSP account is not worth the same as $10 in an non-registered account. Thanks!

  11. Mike April 25, 2014 at 4:16 pm #

    Dan – thank you very much for this post and for the white paper. Based largely on this website I fired my money manager and enthusiastically adopted the couch potato approach about a year ago. The only thing that I have found to be difficult is asset allocation to registered vs. non-registered accounts. This information is extremely helpful.

  12. DJ April 25, 2014 at 6:49 pm #

    Excellent white paper Dan. Thanks to both you and Justin for the insightful work you share. Always appreciated!

  13. Dan Hallett April 26, 2014 at 1:41 pm #

    Rick Ferri’s observation is a very good one. Similarly, by having a policy of 100% bonds or stocks in any account, it makes rebalancing problematic. Accordingly, we usually like to have a small allocation to either stocks or bonds in all accounts. So registered accounts may be mostly bonds but not entirely. Similarly, non-registered accounts will have some bonds but mostly stocks.

    Another thought…accounts with more restrictions like locked in accounts may be most suitable to hold the assets with the lowest expected return. Similarly, an argument can be made to hold in your TFSA the assets with the highest expected return over time. The idea being that you not only save the tax on what could be a higher return but you accumulate as much as possible in the account with the fewest restrictions and lowest tax impact.

    There are always additional considerations when it comes to asset location but what you’ve laid out – i.e. using numbers – should be the main guide. Then the location can be tweaked based on practical or behavioural related factors.

  14. Canadian Couch Potato April 26, 2014 at 4:59 pm #

    @Dan: Thanks for the comment. All goods points. The “optimal” asset allocation often depends on the investor’s specific circumstances, including locked-in accounts, planned future contributions, liquidity needs, etc.

  15. Golluk April 27, 2014 at 4:46 pm #

    I apologize for going rather off topic with the following question, but it does relate to retirement investing at least.

    I’m trying to figure out what happens when one intentionally over contributes to their RRSP, then withdraws back down to their deduction limit. I’m aware there is a 1%/month tax on the amount in excess, but I’m unsure of the implications to your income for that year.

    Say your deduction limit is $24,000, and you move $30,000 into your RRSP account in May. A week later, you withdraw $6,000. The bank withholds 20%, gives you a $4,800.oo, and a T4RSP slip. You are also required to file a T1-OVP form, and pay 1% of the excess ($60). Leaving you with $4,740.00.

    When you file for that year, the RRSP withdrawal has increased your income by $6000. Effectively, you pay income tax twice on that money, since it was not deducted as an RRSP contribution. Once when you get it as a paycheck, and again when you make the RRSP withdrawal. This seems a bit crazy, and far higher penalty than the 1%/month if true.

    Now, there is a T3012A form which appears to allow you to withdraw from your RRSP, without a withholding tax. However, the form requires that “I did not make the contributions intending to withdraw them later and deduct an amount from my income for the withdrawal.” And even then, I’m not sure if will be counted as income?

    I think I’m getting into the realm of tax specialist.

  16. Jeff May 1, 2014 at 4:08 pm #

    Do bonds make sense in a LIRA for younger investors?

    I would suggest treating a LIRA like a pension plan- allow it to influence the overall asset allocation percentages (as these investments will lower the need to take risk) and then exclude it from the application of these percentages.

    I have heard that the 30 year standard deviation for stocks is actually lower than the 30 year standard deviation for bonds. And, of course, the 30 year expected return for stocks are also higher.

  17. Canadian Couch Potato May 1, 2014 at 4:22 pm #

    @Jeff: I’m not sure I would treat a LIRA as fundamentally different from an RRSP. It really bears no resemblance to a pension plan. I would simply consider it as an additional tax-deferred account, so bonds may indeed be the right choice there.

    I don’t know the 30-year standard deviation on bonds or stocks, but investors don’t respond to volatility on 30-year time scales. When markets plummet, they react immediately. Bonds are in a portfolio to dampen short-term volatility, not to increase long-term expected returns.

  18. Satuk December 14, 2015 at 1:15 pm #

    Hi

    I follow the model portfolio option2-TD e series for both my RRSP and TFSA. I have maximized these accounts and looking to invest additional funds. Can I invest in TD eseries funds for my non registered account as well? I don’t have funds more that 50K to go for investing in ETFS. What would be the option if you have some extra amount available to invest beyond RRSP and TFSA. Thanks

  19. Canadian Couch Potato December 15, 2015 at 8:22 am #

    @Satuk: e-Series funds can also be held in non-registered accounts. It usually makes sense to hold the most tax-efficient asset classes in the non-registered accounts first. This typically means Canadian equities, followed by US equities and then international equities. Bond funds are not usually recommended in taxable accounts.
    http://canadiancouchpotato.com/2010/03/05/put-your-assets-in-their-place/

  20. Satuk December 15, 2015 at 9:22 am #

    @CCP: Thank you for pointing me to the link. Helpful information. If I go for iShares S&P/TSX Capped Composite (XIC) or iShares S&P/TSX Canadian Preferred Share (CPD), do I need to open a trading account? I like the simplicity of e-series funds. I buy it online through my TD internet banking account. If I go for e-series then I hold 3 funds instead of 4 that I currently do as per model portfolio in my RRSP and TFSA.

    Is there a threshold portfolio value where I need to move out of e-series funds in non registered accounts or can I continue as long as I wish? As I said earlier, I like the simplicity of buying these funds. May be there is information already on this site but I am requesting again-Is there a link to a model portfolio for non-registered accounts on this site somewhere? Appreciate if you could point me there. Thank you.

  21. Canadian Couch Potato December 16, 2015 at 7:58 am #

    @Satuk: You can stay with the e-Series funds as long as you are comfortable with them. I think too many people are in a hurry to switch to ETFs.

    There’s no single model portfolio for non-registered accounts (at least not on my site). I encourage people to think about their investments as single large portfolio and then make smart asset location decisions based on their individual circumstances.

  22. Satuk December 16, 2015 at 9:12 am #

    @CCP Thank you for the information. Appreciate it much.

  23. gocanada August 22, 2017 at 3:24 am #

    What is your view on bonds within a TFSA? I know that your whitepaper didn’t initially discuss this due to the low contribution room at this time; however, the room of course continues to grow. Also, for those who have a partner/spouse, the combined contribution room can be somewhat significant.

    It seems to me that putting bonds in a TFSA may be even better than in an RRSP, as the RRSP seems like a better place for equities over TFSA, given that the TFSA has a lot less advantages for avoiding or reclaiming foreign withholding taxes (assuming I understand your whitepaper on foreign withholding taxes correctly).

    ETFs like HBB seem to complicate this question further, as you can get the bond yield in the form of capital gains – and with lower bond yield rates these days, this seems like a decent option too.

  24. Canadian Couch Potato August 23, 2017 at 10:30 am #

    @gocanada: In general, I believe it makes more sense to keep high-growth assets (equities) in the TFSA as far as possible. Any drag from foreign withholding taxes is likely to be very small compared with the enormous advantage of the TFSA’s lifetime tax-free status:
    http://www.canadianportfoliomanagerblog.com/asset-location-tax-savings-through-more-organized-living/

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