Yesterday’s federal budget included several changes that will affect investors—in the future if not immediately. Let’s look at the three most important announcements, with a focus on how they may apply to those who use an index strategy with ETFs:
- The biggest headline was the increase in annual TFSA contribution room from $5,500 to $10,000, beginning immediately.
- Minimum withdrawals from RRIFs were reduced significantly.
- Investors who hold foreign property (including US-listed ETFs in non-registered accounts) will be able to report this to the Canada Revenue Agency in a more efficient way.
Asset location just got more interesting
If you’re juggling TFSAs, RRSPs and non-registered accounts, asset location is a challenge. To manage your portfolio in the most tax-efficient way, you should consider which asset classes (equities, bonds, REITs and so on) are best held in which type of account. This isn’t straightforward. You can make a strong argument for holding bond ETFs in a registered account because they are so tax-inefficient. But if a TFSA can shelter you from taxes over an entire lifetime, shouldn’t it be reserved for assets with the highest growth potential—in other words, stocks?
There is no single right answer: an awful lot depends on individual circumstances such as your current tax rate, your expected tax rate in retirement, whether you need liquidity, the size of your portfolio, your overall asset mix, and the specific funds you use. And let’s not forget that the most important driver—the future returns of stocks and bonds—can never be knowable in advance.
That said, the changes announced in Budget 2015 will have an important influence on asset location decisions in the future. In a white paper published last year, Asset Location for Taxable Investors, Justin Bender and I didn’t even include TFSAs in our analysis, because at the time you could only contribute a modest $31,000. “If you have a maxed-out RRSP and significant non-registered savings,” we wrote, “this amount would not represent a significant portion of your net worth. That will change in the future, but for now TFSAs are not a major factor in the asset location decision.”
With TFSA contribution room now almost double what it was, the thinking about asset location will need to evolve. Right now, if you’ve maxed out your RRSP and your TFSA, chances are the former is much bigger—indeed, for well-off investors the RRSP might be 10 or 20 times larger. But for younger folks earning modest incomes, TFSA room will now accumulate more quickly than RRSP contribution room. And by the time they’re in their peak earning years, the TFSA may supplant its older cousin as the primary retirement savings vehicle.
The new lower minimum RRIF withdrawal rates will also affect asset location decisions. In our paper, Justin and I argued that investors need to consider the future tax implications of forced RRIF withdrawals in retirement. That was an argument for holding bonds in an RRSP and equities in a taxable account (assuming RRSPs were maxed). “Holding higher-growth equities in an RRSP would defer more taxes today, but the investor would also end up retiring with a larger registered account (relative to if they had held lower-yield fixed income). That could result in significantly higher tax bills during retirement, as well as a clawback of Old Age Security benefits.”
Under the new rules, the required withdrawal rate will be 5.28% at age 72, down significantly from the current 7.38%. For an investor whose RRIF is valued at $500,000, that reduction amounts to about $10,000 a year. So the new RRIF schedule will allow seniors to draw down their registered accounts more gradually, keeping their taxable income lower in retirement. That makes the argument for holding low-growth investments in RRSPs less compelling than before.
A break for those with US-listed ETFs
Finally, in one of the less publicized budget announcements, the feds made life a little easier for investors who hold US-listed ETFs in their taxable accounts. If you filed a tax return this month your accountant or advisor may have explained that the CRA requires you to report specified foreign property over $100,000 by filing a T1135 report.
Unfortunately, recent changes to the T1135 are onerous and confusing. The government admitted this in the budget text: “Stakeholders have commented that this approach has resulted in a compliance burden for some taxpayers that may be disproportionate to the amount of their foreign investments.”
According to the budget announcement, things should be easier next year, at least for those whose holdings in US-listed ETFs are between $100,000 and $250,000: “Under the revised form being developed by the Canada Revenue Agency, if the total cost of a taxpayer’s specified foreign property is less than $250,000 throughout the year, the taxpayer will be able to report these assets to the Canada Revenue Agency under a new simplified foreign asset reporting system.”