My wife and I have a portfolio that is scattered around a bunch of different places—a mutual fund company, a bank investment arm with an advisor, an employer pension-matching plan plus stock options and a self managed discount brokerage account. I am concerned about this. Even though I keep track of the total portfolio using a personal spreadsheet I wonder if I should consolidate all of it into one location?

PS: My wife won’t let me touch her portfolio with the mutual fund company.

Answer:

Imagine taking the contents of your spice rack and scattering them around the kitchen: Cumin by the coffee maker, nutmeg with the knives and paprika peaking out from underneath the potato peeler. While dinner would eventually find its way to the table, it would likely be a time consuming and frustrating cooking experience.

Finding the right level of complexity for your money is one of the most important things you need to do to be a smart person doing more smart things with your money. A lot of people have either too much complexity to keep a handle on everything, or too little to get the results they want.

In your case, it sounds like too much complexity. I have outlined how I suggest you simplify things in this related post, Retirement planning: The question you need to ask yourself. But first let me say that I understand why you’re concerned. Having a portfolio scattered around at different places exposes you to a number of risks. For example:

Over/under diversification

You want some exposure to different asset classes, sectors and geographies—but not too much and not too little. A scattered portfolio makes it harder to gauge how much exposure to a particular stock or sector you actually have. For example, if you hold multiple Canadian Equity mutual funds you might be over diversified—holding a small bit of everything such that your portfolio is unlikely to perform well compared to the benchmark. And you might be under diversified when it comes to your individual stock holdings. You say you have options through your employer, but you’ll want to make sure that those shares don’t dominate your portfolio. That is harder to assess when every thing is scattered around.

As everyone knows, an RRSP account is where retirement savings goes. But less people know how to structure the account to make sure there’s something left at retirement. It comes down to one thing, says Gardner; holding long-term assets. Whether it’s a fund, ETF or stock, the investment needs to last for years, if not decades.

That means owning large-cap investments. Typically, larger companies with a market capitalization of at least $10 billion are safer than smaller ones. A mutual fund that holds Canadian bank stocks won’t rise in value as quickly as one that holds junior mining firms, but it won’t fall nearly as quickly either. Not only do large caps decrease volatility, but these companies, especially multinationals, aren’t nearly as likely to go bankrupt. A fund that holds decades old brands such McDonalds and Coca-Cola, for instance, will likely be around for the long-term.

AJ Sull, president and chief investment officer with Vancouver’s Pacifica Partners Capital Management, says dividend-paying companies should also be an integral part of an RRSP portfolio. There’re good for two reasons, he says. The first is that people don’t have to worry too much about whether their investments are increasing in value; regular dividend payments will keep money flowing into account. “You’re getting paid something while you wait for the stock price to rise,” adds Gardner.

The second is that dividend payments allow Canadians to buy more fund units or ETFs without adding to the principal. Ultimately, the more assets you own the more you’ll have when it’s time to retire. Imagine how much larger your portfolio will be after reinvesting dividends for 30 years.

Not only do Canadians have to buy long lasting investments, but a good RRSP also has the right asset allocation. Steven Belchetz, president and chief investment officer with Toronto’s T.E. Wealth, says that retirement portfolios need to be diversified globally. Canada’s market is concentrated in just three sectors, financials, materials and energy, so having too much domestic exposure could be risky.

For the equity part of an RRSP, Belchetz recommends having 50% of assets in Canadian securities, 25% in the U.S. and 25% in international markets. You still want to be more heavily weighted towards domestic securities because of the currency risks around non-Canadian investments.

When it comes to bonds or bond funds, what to buy depends on risk tolerance. Government bonds yield around 2%, but they’re extremely safe. Corporates have a better yield, but they’re riskier. Either way, the basic rules around age and asset allocation remain; own less bonds when you’re younger and more when you’re older. Sull says investors should have, at minimum, 20% of their RRSP assets in fixed income.

By sticking to large-cap, dividend-paying securities your retirement should be secure. Save your risky buying and selling for another account, says Gardner. “No matter if it’s an ETF or mutual fund, RRSPs should hold the core long life assets,” he says. “It’s not for the newest and craziest trading strategy.”

To figure out the right mix for your retirement needs, start with a few simple questions. How long will the money stay invested? How much risk are you willing to take with your savings? How much growth do you need? “The only way to properly answer those questions is to put together a comprehensive financial plan that sets out your short- and long-term financial goals,” says Marc Lamontagne, a fee-only adviser with Ryan Lamontagne in Ottawa.

The biggest and most important question you’ll likely face is how to balance your risk with the amount of growth you need. Generally speaking, the longer your money is invested the more risk you can afford to take on. But how do you determine your tolerance for risk? “I like to use a questionnaire with my clients,” says Lamontagne. “It allows us to open up a discussion that allows us to gauge their risk tolerance. If they’re a couple and they each have a very different tolerance for risk, then I generally help them reach a compromise, keeping in mind that the compromise will allow both of them to reach their financial goals.”

To get the maximum return while taking the minimum amount of risk, it helps to think of your portfolio as being split into two parts: an equity portion comprised of stocks, and fixed income portion made up of bonds, GICs and savings accounts. Generally speaking, the higher the percentage in equities, the higher the risk.

Keep in mind that while stocks will earn you a higher return over the long run, their short-term performance is harder to predict. If you’re 30 and retirement is a long way away, you can take a few market crashes in stride and still come out ahead, so you can take on more risk. But if you’re getting close to retirement, you should probably decrease your stock holdings and go heavier on bonds, as they’re more predictable so you’ll suffer less damage from a market slump.

A good rule of thumb is to put a percentage in fixed income that is equal to your age. If you’re 40, for instance, you could put 40% in fixed income and 60% in stocks. If you’re 60, you could put 60% in fixed income and 40% in stocks. The exact proportions depend on your risk tolerance. You can also help insulate yourself from market declines by building up a pool of cash and GICs, or a short-term bond ladder. If you build up enough to fund three years’ worth of expenses, you won’t have to sell off stocks when the market is down.

Still, you don’t want to get too conservative: “If a retirement portfolio is to last you to age 90, it should not be invested only in cash and GICs,” says Norm Rothery, a chartered financial analyst and founder of StingyInvestor.com. “There should be a minimum 25% holding of equity—regardless of age. Such a portfolio actually has less risk than one invested 100% in fixed-income investments because it will protect you from the risk of inflation.”

Once you’ve established the right mix of equities and fixed income, then it’s time to choose your individual -investments. The -investment vehicles you pick depend on several factors, including the amount of time you want to spend on your portfolio. You can buy individual stocks and bonds, but this is best left to more experienced investors. Mutual funds and index funds are likely more convenient and practical.

If you’re a new investor, then a simple balanced mutual fund can be a great place to start. “They usually contain a conservative 60% equity and 40% fixed income mix all in one product,” says Rothery. Experienced investors who want a more hands-on -approach may also want to look at exchange traded funds (ETFs) or index mutual funds.

For a more detailed analysis of the right mix for you, consult a knowledgeable -adviser, who can help you pick the perfect investments for your particular situation and goals. Check back with your adviser regularly to ensure that your overall mix and risk level stay on track as your financial situation and time horizon changes.

I’m pretty conservative by nature. My pantry is so well stocked I could feed Brangelina’s entire brood for a year. So it won’t surprise you that I have used a number of those retirement calculators online to figure out how big a nest egg I’m going to need. What I want to know is, what I might have forgotten in my calculations.

Answer:

In case I get the munchies during a nuclear war, I now know where to call. Thanks for the reassurance.

Now, first, let me say that just figuring out a number—any number—puts you ahead of most people. Well done. You’re right that there are a few pitfalls to be aware of, and not just for ultra-conservative people like you. For example:

Going into too much detail

Calculating what you need is part science, and part science fiction. Remember, you are just coming up with an estimate—your best guess based on what you know now. There is no way to know what the actual number will be. So going into too much detail can lead to overconfidence because you think you’ve ‘figured it out’.

Neglecting family health history

If you have longevity in your family, you need to plan for it. The same goes for ill health, either for you or a family member who is going to need additional support after you retire. This could include a relative with special needs or a parent who still needs care after you stop working.

The Vancouver-based writer talks excitedly about opening her RRSP account at 22, long before most of her peers. But, she hesitates a bit when describing how she used to contribute back then.

“I was haphazardly putting in a lump sum,” she says. “I just put in whatever was left over.”

That changed about two years ago, when she started using index funds. Instead of depositing some money into her account at the end of the year, she began transferring a specific amount each month from her savings account into her RRSP.

While her $200 a month payments make up about 75% of her annual contributions, she can’t completely get away from the lump sum approach. At the end of the year she’ll add whatever cash she has left over into her RRSP.

Alison Griffiths, author of the recently released Count On Yourself: Take Charge of Your Money, says both options can work, but regular deposits are better. It forces people to save, she says. Simply set up an automatic withdrawal and leave it at that.

“The money goes out and you don’t have to worry about it,” says Griffiths.

Another reason to use the monthly withdrawal method, which is often referred to as dollar cost averaging, is because it can make investing less volatile. Since you’re investing the same amount each month, you’re not trying to time the market. If the market is down one day you end up buying more mutual fund or ETF units; if it’s up you buy less. In the end it should even itself out.

“Dollar cost averaging smoothes those bumps,” Griffiths explains.

But don’t count out the lump sum payments. Do-it-yourself investors who buy online usually have to pay commission fees on their transactions. If you’re spending $200 a month, and paying $29 each time you buy an ETF—the fee you’re typically charged if you don’t have over $50,000 of assets at the bank—you’ll end up giving your financial institution 14% of your intended RRSP payments each month.

In that case, Griffiths suggests setting money aside in a savings account and then depositing the cash into the RRSP once or twice a year.

But when’s the best time to contribute that lump sum? The earlier the better, says Griffiths. “If you’re getting a 3% dividend and can start that on January 1 instead of December 31, the extra year can really make a difference,” she explains. In other words, don’t wait until you have some leftover cash to make a contribution.

Clare isn’t investing through an online brokerage so she doesn’t have to worry about the transaction fees. And because she’s set up automatic withdrawal each month, she really doesn’t have much to worry about at all.

“I feel so much better,” she says about changing her RRSP contribution method. “I pay myself first now. And I like not seeing all that money sitting in my savings account—I don’t have the temptation to spend it.”

2. Pay yourself first. Set up an automatic transfer to your RRSP, TFSA or other savings account every two weeks to coincide with your paycheque. You won’t even miss the money after a while, and if you save enough automatically, you can spend the rest guilt-free.

3. Cancel that expensive gym membership. You can easily spend up to $800 a year at a high-end club. Instead, look to programs at your local recreation centre—the fees can be as low as $10 a month.

4. Install a programmable thermostat. These devices regulate the temperature in your house automatically according to the schedule that you set. You can save 10% to 20% a year on your energy bill.

5. Trim wasted spending. Examine your budget for expenses that can easily be trimmed. For instance, it may be worth raising the deductible on your car or home insurance to reduce your monthly payments. Choosing a $2,000 deductible instead of a $500 deductible can save you 25%.

6. Exploit your benefits. Visit your company’s HR department and ask about job perks. You may be eligible for a great pension or low-cost group RRSP, plus company discounts and free workshops and seminars.

The standard advice is to put Canadian stocks in non-registered accounts, and put fixed income investments, such as bonds and GICs, inside RRSPs and TFSAs. Tax rates are lower on the Canadian dividend income and capital gains you get from stocks than they are on the interest income you get from bonds and GICs, so keep your stocks outside your RRSP where taxes matter, and then hold your bonds and GICs inside.

U.S. equities are more complicated. Dividends from U.S. stocks are taxed in Canada at regular rates, just like interest income. But capital gains on U.S. stocks—which you trigger when you sell a stock at a profit—are taxed favorably just like capital gains on Canadian stocks. So it makes sense to hold U.S. stocks that pay little or no dividends inside your non-registered accounts alongside Canadian stocks. On the other hand, U.S. stocks that pay handsome dividends probably fit better in your RRSP.

There is an added U.S. tax wrinkle here: the Internal Revenue Service levies a 15% withholding tax on dividends on U.S. stocks held by foreign investors (these are deducted automatically). If a stock pays a 3% dividend, then, the withholding tax would reduce it to 2.55%.

Fortunately, if you hold U.S. stocks in non-registered accounts, you get a credit for the amount withheld that you can apply against Canadian income taxes, so in most cases that leaves you square—providing your Canadian tax rate is at least 15%.

In the case of RRSPs and other retirement accounts, Canada has a tax treaty with the U.S. that exempts you from the withholding tax. But if you hold U.S. stocks in a TFSA or an RESP, you’re dinged the 15% levy and you can’t get it back. As a result, you’re best off holding U.S. stocks that pay hefty dividends inside your RRSPs, and keeping them outside of your TFSAs and RESPs. Who knew?

Keep in mind that dividend withholding tax amounts and treatments vary among other countries, so don’t count on the advice for U.S. stocks applying to stocks from overseas.

“I kind of understand how the dividend tax thing works, but I don’t really know the details,” admits Clark, who is 62 and semi-retired. “I just know it’s better than other types of income.”

Clark isn’t alone in his confusion. Of all the mysteries on your tax return, few are as daunting as the treatment of Canadian dividends. We know that dividend income gets preferential tax treatment, but we don’t know by how much, or why.

To help you really understand how dividend income saves you money at tax time, we’ve enlisted the help of a couple of tax experts. We asked Camillo Lento, a chartered accountant and lecturer at Lakehead University in Thunder Bay, Ont., to calculate how much tax an investor would pay at three different income levels if he earned $1,000 in Canadian dividend income, compared with the same amount in interest income. We’ve compiled the results in the accompanying table, “How much will you save with the dividend tax credit?” (We crunched the numbers for Ontario specifically, as the benefit in that province falls in middle of the pack.) We also got help from Ross McShane, director of financial planning at McLarty and Co. Wealth Management in Ottawa.

Not surprisingly, the results show that investing in Canadian dividend-payers will save you a bundle. But just how sweet the deal is depends on your income. As with many features of our tax system, the benefits are greatest at moderate income levels, and not as attractive as your income rises.

In what follows, we’ll do our best to explain the calculations and show you how you can get the largest tax benefit possible. Get out your calculators, and we’ll begin. Also, read about how to handle your U.S. dividend stocks.

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The sweet taste of taxes saved

If you earn $25,000 a year, the tax benefit you’ll get from Canadian dividend income is enough to make an accountant drool. You not only pay no tax at all on your $1,000 in dividend income, but get this: you actually reduce your taxes on other income. Although the reduction in other taxes is only about $40, that’s still a rare and wonderful thing, what accountants call a “negative marginal tax rate.” All told, after earning $1,000 in dividend income you’re a full $240 ahead of where you’d be after earning the same amount in interest income. That’s about as sweet as it gets.

At higher income levels, the tax savings on $1,000 in dividends is still very good, but not quite as delectable. When we ran the numbers for people earning a total income of $50,000 and those earning an income of $85,000 for our table, we found that you come out ahead by almost $200 when you earn $1,000 in dividends compared to $1,000 in interest income (assuming that you’re under 65). That’s not as exciting as getting tax money back outright, but your inner accountant will still be pleased.

Unfortunately, there’s a complication if you’re 65 or older and subject to the dreaded Old Age Security (OAS) clawback, which applies to seniors with incomes of $67,700 and above. That’s because dividend income counts for more than regular income in calculating the OAS clawback amount. As a result, a senior earning $85,000 would save only $173 in taxes when he or she earns $1,000 in Canadian dividends, compared to the same amount of interest income. The deal is still sweet for affluent seniors, but it will leave you with a sour aftertaste from the clawback. We’ll come back to this later.

A method behind the madness

Now we’ll reveal the secrets of the dividend tax calculation. It turns out the math is so convoluted for a reason.

The best way to understand how taxes on Canadian dividends are calculated is to take a quick three-step tour. First you take your dividend income and multiply it by 1.41, which is what’s known as the dividend “gross-up.” That means $1,000 in dividends becomes $1,410 in income. (The 1.41 figure is for the 2011 tax year and will change in 2012. The good news is that you don’t actually have to do this on your tax return: the government makes financial institutions gross-up dividends before sending out your T3 and T5 slips.)

Second, you take the grossed-up dividend income and apply your marginal tax rate to figure out your taxes so far. If you live in Ontario and earn $50,000, your marginal tax rate is 31.2%. So that works out to $439 in taxes payable on $1,410 in income.

At this point you’re probably not having much fun, because it feels like you’re set up to pay taxes on the inflated amount. Fortunately, there’s a third step that knocks those nasty taxes back down: you get to apply the dividend tax credit. This is another figure you get from your T3 and T5 slips, and it comes to 22.8% of the grossed-up dividend amount. In this case, that would mean a credit of $322 on your grossed-up $1,410 in income. Now you subtract that credit from the taxes payable, in this case, $439. That leaves you with a final tax bill of just $117. Since the benefit of the tax credit is larger than the impact of the gross-up, you end up ahead.

But why does the tax man make you jump through all these hoops? Why not simply charge a lower rate on dividends from the get-go and make it simpler for everybody?

The reason is that tax authorities have their eye on the big picture. “It’s all about tax integration,” says McShane, the financial planner. Think of it this way: the money you receive as dividends starts off as a company’s earnings, and the company pays corporate taxes on those earnings. After paying those taxes, the company takes a portion of the money that is left and passes it directly to you as a dividend, and you pay tax on it again.

The government recognizes that it’s unfair to tax the same income twice. So they give you a break on dividend taxes to offset the taxes the corporation already paid. As a result, you should pay roughly the same tax as if the income had come straight to you in the first place, without passing through corporate hands.

Now that you know what the tax authorities are trying to do, have another look at the three-step calculation. Step one, where you apply the gross-up, brings your income back to the starting point, as if the corporation had never touched it. Step two applies your marginal tax rate to this income, again as if it had never gone through corporate hands. Then step three applies the dividend tax credit to give you back the taxes the corporation actually paid. In general, if your marginal tax rate is higher than the corporate tax rate, you’ll still pay some tax: roughly the difference between the two rates. If your marginal tax rate is lower than the corporate tax rate, you’ll typically get some money back. However, you won’t ever get a cheque from the Canada Revenue Agency: the dividend tax credit is “non-refundable,” which means it can only be used to offset tax otherwise payable on other income.

Before you count on the dividend tax break too much, you should realize that it has been gradually shrinking. That’s because the federal government has been phasing in reduced corporate income tax rates from 2007 to 2012. Since the dividend taxes you pay are based on the difference between your personal tax rate and the corporate tax rate, this means your share of the taxes paid is getting larger. The consolation prize, as Lento points out, is that (in theory) the reduction in corporate taxes should allow companies to increase their dividends.

The dreaded clawback

For affluent seniors, the real unsavoury morsel is the OAS clawback. Remember our first step in the calculation, which inflates a dollar of dividends to $1.41? Well, it’s that grossed-up income that’s used when determining the clawback. Thanks to this seemingly twisted math, dividends can appear less desirable than interest income in this situation.

As you can see in our table, for the senior with an income of $85,000, an extra $1,000 in interest income reduces OAS by $150, but the same amount of additional dividend income reduces OAS by $212.

The tax authorities use a similar approach to calculate other clawbacks on income-related seniors’ benefits, including the Age Credit, which is shown in the examples laid out in our table. The same principle also works against lower-income seniors who are potentially eligible for the Guaranteed Income Supplement (GIS). The GIS is reduced in proportion to your other income, and it too uses grossed-up dividends when making the calculation.

Most seniors feel a bit cheated when they learn that dividends affect the clawbacks in this way. But remember, when it applies to OAS, you’re still ahead of the game. “Even though they’re giving back some of the OAS, the retiree is still further ahead overall with a dollar of dividends rather than a dollar of interest,” says McShane. So while you may have to scoop out that fly in your ice cream and set it aside, your dividends are still likely to provide a tasty meal.

Should you treat U.S. stocks differently?

By this point you no doubt realize that the tax break on dividends only applies to Canadian stocks, not U.S. stocks. As a result, you need to treat the two differently when fitting them into your portfolio.

The standard advice is to put Canadian stocks in non-registered accounts, and put fixed income investments, such as bonds and GICs, inside RRSPs and TFSAs. Tax rates are lower on the Canadian dividend income and capital gains you get from stocks than they are on the interest income you get from bonds and GICs, so keep your stocks outside your RRSP where taxes matter, and then hold your bonds and GICs inside.

U.S. equities are more complicated. Dividends from U.S. stocks are taxed in Canada at regular rates, just like interest income. But capital gains on U.S. stocks—which you trigger when you sell a stock at a profit—are taxed favorably just like capital gains on Canadian stocks. So it makes sense to hold U.S. stocks that pay little or no dividends inside your non-registered accounts alongside Canadian stocks. On the other hand, U.S. stocks that pay handsome dividends probably fit better in your RRSP.

There is an added U.S. tax wrinkle here: the Internal Revenue Service levies a 15% withholding tax on dividends on U.S. stocks held by foreign investors (these are deducted automatically). If a stock pays a 3% dividend, then, the withholding tax would reduce it to 2.55%.

Fortunately, if you hold U.S. stocks in non-registered accounts, you get a credit for the amount withheld that you can apply against Canadian income taxes, so in most cases that leaves you square—providing your Canadian tax rate is at least 15%.

In the case of RRSPs and other retirement accounts, Canada has a tax treaty with the U.S. that exempts you from the withholding tax. But if you hold U.S. stocks in a TFSA or an RESP, you’re dinged the 15% levy and you can’t get it back. As a result, you’re best off holding U.S. stocks that pay hefty dividends inside your RRSPs, and keeping them outside of your TFSAs and RESPs. Who knew?

Keep in mind that dividend withholding tax amounts and treatments vary among other countries, so don’t count on the advice for U.S. stocks applying to stocks from overseas.