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.