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|
|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.
Hate to bother you with this simple question. Does one get the dividend tax credit (non registered) with an etf like VCN or does it have to be individual Canadian stocks?
Hi Dan! I’m in the fortunate position to have maxed out my RRSP and TFSA and now looking to invest in my taxable account. I use a 5-ETF portfolio using ETFs recommended by your older portfolio and Justin Bender. I’m wondering if it makes sense to use the same ones for my taxable account. For example, I use VCN for my Canadian equities portion and I’m wondering if I should seek a more tax efficient alternative for my taxable account. I don’t mind the extra work (I have a spreadsheet that works well for me). I have followed prior advice and put all my bond equities in my RRSP.
I use VCN, XUU, XEF, XEC, and ZAG.
@Erin: All of the ETFs you list are perfectly fine in a taxable account, with the exception of ZAG. ZDB would be a more appropriate choice: see Justin’s model portfolios for more details.
@Dan Thanks so much!!!!! I can’t speak enough about how much your work has helped me organize and educate myself. Big kudos to you and Justin.
@Dan – Follow-up question, if you do not mind. Assuming it’s possible for my overall portfolio, is it ideal to only hold Canadian equity ETFs in my taxable account and allocate the rest in my RRSP and TFSA accounts? Or are there benefits to having a mix of ETFs in my taxable account as well?
For example, I can stick to purchasing VCN (Canadian equity ETF) in my taxable account and replace VCN in my RRSP/TFSA with International / US ETFs when rebalancing. I was thinking that this would be best for tax purposes and it’s not a problem for me to add this logic into my spreadsheet (If anything, it’s a bit fun!).
@Erin: In theory this is fine, but you may find that you cannot maintain a tidy asset location. For example, if you need to rebalance by selling bonds and buying Canadian equities, you would not be able to do so if the bonds are in your RRSP and the Canadian equities are in your non-registered account. That’s why I typically recommend that DIY investors do not worry about optimizing asset location, as it can get complicated for very little benefit.
@Dan, first of all, thank you for all you have done for us.
Years ago, I adopted a CCP portfolio consisting of:
To me, this seems similar to VGRO, but the MER is 0.162 instead of 0.25 so I stick to it and re-balance quarterly.
I maxed out my TFSA and put away a few thousand into an RRSP every year. For some reason, I’ve only been holding XAW in my RRSP and the TFSA has a distribution of all three to maintain the allocation overall. For some reason, I thought this approach was more tax efficient, but in the end, given that these are all in registered accounts, should I just spread them evenly across both accounts? Does it make any difference whatsoever?
@Xavier: In the vast majority of cases, those with TFSAs and RRSPs are better off using a fund like VGRO in both accounts and not bothering with trying to optimize asset location. The small difference in MER is likely to be offset by the many other benefits that come from using a one-fund solution: fewer transactions, enforced rebalancing and much less complexity.
Thanks for everything Dan! It’s awesome that your still replying to this thread. I read threw the 2017 and 2019 white papers on asset location from PWL. They’re good and I was hoping to get a definitive answer out of them…but this article and your responses put everything into perspective like only you can. Best wishes.
Is this article valid in 2021?
@John: The tax rules have not changed. However, the products mentioned in the blog may have evolved. Over the years my advice about asset location has evolved, too. I’ve learned from experience that trying to optimize “what goes where” is usually counterproductive, as it makes rebalancing very difficult, and many DIY investors have a hard time with the increased complexity. Most are probably better off simply using an asset allocation ETF in both their TFSAs and the RRSPs, at the very least, and probably using the same in a taxable account, too.
Good evening Dan,
Didn’t know where to post this so I am placing it here.
Thank you for writing you latest book. Your first small book was excellent for me at the time and now this one is excellent to read and share the knowledge. I purchased 4 to date, 1 for me and 3 to share. I have been providing financial sessions to my summer students for years. I hand out books by Andrew Hallam, JL Collins, and the grand mater Mr. Bogle. Yours will be my next one to purchase by the dozen.
Thank you Dan, much appreciated
@AJB: Thanks so much for your kind support. I’m humbled to be named among the other authors in your list!
Hi Dan ! Thanks for what you’re doing for the DIY investor’s community !!
I’ll be investing for the first time in my wife’s taxable account. I’ve read a lot of articles on your blog about asset location and took the decision to replicate the same portfolio (stocks/bonds) in all our accounts for simplicity purpose. For me, I’m using ETF so the only change I’ll do is to replace ZAG by ZBD for tax efficiency. My question if for my wife. She’s using the TD-eSeries Model portfolio. Is there is an alternative to the bond portion (TBD909) that is more tax efficient ???
@Phil M: Thanks for the comment. Unfortunately, there is no discount bond option for index mutual funds.