Everyone talks about the importance of asset allocation, which is critical to ensure you have the right mix of equities, bonds and cash in your portfolio. But very few commentators talk about the best way to divide the asset allocation between accounts to minimize your tax bite for the long term. My current portfolio is roughly 60% equities and 40% bonds. What’s the best way to divide my portfolio between my RRSP, TFSA and non-registered accounts?
You need a few ingredients to make a batch of butter tarts—sugar, butter and pastry shells, for instance. You also need a few ingredients to make a well-diversified investment portfolio—some Canadian equity, some U.S. and international equity and a dollop (even a large dollop) of fixed income, perhaps in the form of bonds or a bond fund. As you say, that part of the asset allocation recipe is discussed a lot. But where to store each ingredient isn’t talked about nearly as much.
Keep your kitchen clean and your investment portfolio tidy
Sugar goes in the cupboard, butter in the fridge and pastry shells in the freezer. (Yes. I use store bought pastry shells, don’t judge.) So where should you store your investment ingredients? In your RRSP, TFSA or non-registered account? The choices you make on asset location can have an impact on how much tax you pay. I’ll go through some rules of thumb below, but this is an area where a financial professional can make a big difference—a financial adviser or a tax accountant can help you sort out what makes the most sense for you and provide guidance on what account you should draw from first in retirement.
One thing to keep in mind: asset location is most relevant for people who have maxed out their RRSP and use a non-registered account to hold their other investments. If you still have available RRSP contribution room, then that is probably still your best option for your retirement savings.
Interest bearing investments should be held in registered accounts such as RRSPs and RRIFs. “In all provinces, taxpayers pay half as much tax on capital gains than interest income, so that suggests holding bonds and GICs in your RRSP and stocks in non-registered accounts makes sense,” explains Jason Heath is a CFP with Objective Financial Partners. If that interest is earned inside the RRSP you don’t pay tax on it until you withdraw it as income at some point in the future.
Let’s look at your case as an example. Lets say you have already maxed out your RRSP and that math worked perfectly—you would want to keep all of your fixed income in your portfolio in your RRSP and the remaining 60% in equities in your non-registered account.
Non-registered accounts can be cash or margin accounts owned personally, in a company or in a trust, explains Adrian Mastracci, a fee-only portfolio manager and financial advisor at Vancouver’s KCM Wealth Management. Income from dividends, capital gains and losses, receive preferential tax treatment over interest income, he says. As such, he adds, equity investments are best held in these non-registered accounts for maximum tax efficiency. Depending on which province you live in, the tax rate on dividend income could be one-third to one-half the rate on interest income, which can add up.
But not all dividends are created equal, says Heath. “Foreign dividends are taxed at the same rate as interest, so if your asset allocation is such that you’re going to end up with some stocks in taxable accounts and some in tax-sheltered accounts, I’d lean towards holding the Canadian stocks outside RRSPs and foreign stocks inside RRSPs.”
All income earned in a tax free savings account is tax-fee when withdrawn, hence the groovy name. Mastracci says that while you can mix income types within a TFSA, you will lose any dividend tax credits you may have been eligible for and you won’t be able to use any capital losses you may have incurred to offset gains outside the account. But if have a lower income and predict that your retirement income will be similar to what you currently make, then you may even want to focus on your TFSA, since withdrawals from that account won’t affect things like old-age security.
Preferred shares can be another way to minimize tax
For some investors, investing in Canadian preferred shares is a good way to get some fixed income instead of holding bonds in a non-registered account. That’s because they pay dividend income, which, as you now know, is taxed at a lower rate than interest income. But not all preferred shares get treated the same way. “They have many different features and are issued by companies that have different risk profiles,” says Heath. So don’t think that holding preferred shares that pay a nice dividend are as safe as a boring old government bond. It ain’t.
Both Mastracci and Heath have been in the business a long time and have many seen clients show up at their doors for the first time with the same asset allocation in both registered and non-registered accounts. Moving some of one ingredient from the fridge to freezer can mean a significant reduction in your tax bill. This will free up money for you to spend on butter tarts, and the personal trainer you’ll need to offset your eating them.