If you’ve ever put together an investment plan, you’re familiar with asset allocation. That’s the mix of stocks, bonds, real estate and other investments driving the expected risk and return of your portfolio. You probably gave less thought to asset location, or how those assets are distributed among your registered and non-registered investment accounts. But as any home buyer will tell you, location means a lot.
Here’s why. Investment returns—bond interest, Canadian and foreign stock dividends, capital gains—are taxed in different ways. And each of your accounts—such as RRSPs, TFSAs and taxable accounts—is governed by different tax rules. Savvy investors know if they hold assets in the wrong account type they’ll pay much more tax than necessary.
How much more? That depends on your portfolio size and tax rates, but smart asset location decisions can easily save you tens of thousands of dollars over an investing lifetime. That number could easily top $100,000 for wealthier investors. So yes, it can be a big deal. In some cases, poor asset location will be a bigger drag on returns than the fees you pay for your funds.
Before we get into the gory details, let’s be clear on some important points. First, asset location is not a concern if all your savings are in tax-sheltered accounts, especially if your portfolio is relatively small. If you have some contribution room left in your RRSP or TFSA it rarely makes sense to hold investments in non-registered (taxable) accounts. Asset location becomes important only when your tax-sheltered accounts are maxed out.
Second, tax efficiency should never be the starting point when putting together a portfolio: it should only be considered after you’ve settled on an appropriate asset mix for your risk tolerance and investing goals. “Tax considerations, while valuable, should not drive the decision,” says Nicholas Miazek, vice president and financial planner at Fiera Capital Private Wealth in Calgary. “The tax planning tail should not wag the investment policy dog.” In other words, if you’re a conservative investor with a large non-registered portfolio, you should not buy risky stocks simply because you don’t want to pay tax on bond interest.
The tax man’s share
Let’s begin with a refresher on the main types of investment returns and their respective tax treatments. In the examples below we’ll only look at federal income tax and use the top tax bracket (29%), but keep in mind you have to pay provincial taxes on this income as well.
■ Interest. Interest is earned from savings accounts, GICs and bonds, and is taxed at your full marginal rate in the year you earned it. For an investor in the highest tax bracket, $100 of interest income would be subject to $29 of federal tax ($100 x 29%).
■ Canadian dividends. Dividends from Canadian stocks get special treatment, because companies pay them with after-tax dollars. To avoid taxing those dollars twice, the government allows you to “gross up” the dividend amount, then claim a generous dividend tax credit.
For the 2013 tax year, the gross-up is 38% and the federal dividend tax credit is 15% on that grossed-up amount. The math is a bit complicated, but the bottom line is $100 in eligible Canadian dividends would be subject to just $19.29 in federal tax if you’re in the highest bracket. At lower tax brackets, the advantage is even greater.
■ Foreign dividends. Dividends from foreign stocks don’t get the same tax treatment as those from Canadian companies. They’re fully taxed at your marginal rate, just like interest. So $100 in foreign dividends would be subject to $29 in federal tax.
But that’s only Canada’s share of the taxes. Many countries impose a withholding tax on dividends paid to foreign investors. For example, dividends from U.S. stocks are subject to a levy of 15%. (You need to make sure you’ve filled out what’s called a W-8BEN form or this withholding tax rate will be 30%. You should have been asked to fill this out when you opened your account.) If you hold U.S. stocks with an average yield of 4%, the withholding tax amounts to an extra cost of about 0.60% annually.
Other countries impose different rates, typically between 15% and 25% or more. These taxes can apply even on American depositary receipts (ADRs), which are shares in overseas companies listed on U.S. exchanges.
■ Capital gains. If an investment’s current market value is higher than the price you paid, you have a capital gain.
Capital gains are also taxed quite favourably. First, you pay taxes only when the gains are realized—in other words, when you sell the investment—so you can defer them for many years. When you finally do realize (or “crystallize”) them, you effectively pay tax on only 50% of the gains. So if you have $100 in realized capital gains and a 29% federal tax rate, you’re subject to $14.50 in federal tax. Moreover, if you have realized capital losses on other investments, you can use these losses to offset gains and further reduce your tax bill.
Holding you to account
Now we’ve tackled the basics of how investment income is taxed, let’s look at the accounts used to hold these investments. There are three categories: tax-deferred, tax-free and taxable.
■ Tax-deferred accounts. An RRSP is the most common tax-deferred account, but others also fit this category, such as Registered Retirement Income Funds (RRIFs) or locked-in retirement accounts (LIRAs).
You receive a tax deduction for making an RRSP contribution. If your marginal tax rate is 40% and you put $1,000 in your RRSP, your income is reduced by $1,000 for the year, effectively saving $400 in tax. Inside the RRSP, all investment growth is completely sheltered from tax. But future withdrawals from the account will be taxed at your full marginal rate. It doesn’t matter whether that growth came from interest, dividends or capital gains.
Another advantage of tax-deferred retirement accounts: U.S. stocks held in an RRSP are exempt from withholding taxes, thanks to a tax treaty with our southern neighbour.
■ Tax-free accounts. The Tax-Free Savings Account (TFSA) is the mirror image of an RRSP. Contributions do not generate a tax refund, but future withdrawals from TFSAs are not counted as income for tax purposes. This is especially good news for Canadians who may face clawbacks of income-tested benefits in retirement, notably the Guaranteed Income Supplement and Old Age Security.
A Registered Education Savings Plan (RESP) also fits into this category. Contributions are made with after-tax dollars, investments grow tax free, and any growth is ultimately taxed in the child’s hands, which often means they won’t end up paying any tax at all.
TFSAs and RESPs are not considered retirement accounts, so the exemption on U.S. withholding taxes does not apply. If you hold foreign stocks in these accounts, you will pay withholding taxes on dividends, and these are not recoverable.
■ Taxable accounts. When you put money in a taxable account—also called a non-registered or open account—you receive no income deductions, and all interest and dividend income generated is taxable in the year it’s earned. Capital gains are taxable if and when they are realized. Because you’ve already paid tax on interest and dividends each year, eventual withdrawals from non-registered accounts are not counted as income.
You will pay foreign withholding taxes in a non-registered account, but you can claim an offsetting credit on your tax return. (The amount you paid will be indicated on the T-slips you receive at tax time.)
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What goes where?
OK, time to answer the burning question: which assets should be held in which accounts? There are few hard-and-fast rules, but here are some guidelines.
■ Fixed income. Interest-bearing investments have the least favourable tax treatment, since all (or almost all) of their returns are fully taxable. So as far as possible, you want to keep them in tax-deferred or tax-free accounts.
In fact, these days most bonds are downright dreadful in taxable accounts. Why? Interest rates have been trending down for many years, so most bonds on the market today were issued when rates were higher. Because bond prices increase when yields fall, these bonds are now trading at a premium (that is, their price is higher than their face value). When they mature, the bond holder will suffer a capital loss.
When you hold premium bonds in a taxable account you get hit with a double whammy, says Justin Bender, portfolio manager with PWL Capital in Toronto. “Investors will pay tax at their full marginal rate on the high-interest income, while receiving only half the tax benefit of the capital loss—and only if they have capital gains to offset.” Virtually all bond mutual funds and ETFs are currently stuffed with premium bonds, Bender says, and they will be for a long time, even if interest rates move gradually higher.
If you must hold fixed income in taxable accounts, Bender says GICs are a much better choice than bonds. That’s because GICs are always sold at face value, never at a premium, so you won’t be hit with the one-two punch of high interest payments followed by capital losses.
■ Canadian stocks (and foreign stocks with low or no dividends). Dividends from Canadian stocks and realized capital gains are the most favourably taxed kinds of investment income. So if you need to keep some investments in taxable accounts, stocks that pay Canadian dividends or no dividends (domestic or foreign) should go there first.
Preferred shares are often considered a type of fixed-income investment, but payouts from Canadian preferreds are eligible for the dividend tax credit too, so if you’re looking for income they make a tax-friendly alternative to corporate bonds in non-registered accounts.
Another advantage of holding stocks in taxable accounts is the ability to reduce capital gains by offsetting them with capital losses. When you sell an investment for a loss, you can carry back the capital loss for up to three years or hold onto it indefinitely to offset future capital gains. By monitoring your taxable account and “harvesting” losses as they become available, you can reduce or defer the taxes you pay on capital gains.
■ Foreign dividend stocks. Because dividends from U.S. and international equities are fully taxable, you generally want to tax-shelter foreign stocks with high yields. As we’ve said, U.S. dividends in retirement accounts are not subject to withholding tax, so for those two reasons U.S. stocks are best held in an RRSP.
One important note: the withholding-tax exemption applies only if you directly hold a stock or ETF traded on a U.S. exchange. If your U.S. stocks are held in a Canadian mutual fund or ETF, you will pay the 15% withholding tax on the dividends even in an RRSP, and you won’t be able to recover it.
Some other foreign countries withhold taxes on dividends even if they are in your RRSP, and those taxes are also unrecoverable. If these overseas stocks (including ADRs) are held in non-registered accounts, it’s possible to recover the withholding taxes by claiming the foreign tax credit on your tax return. But because foreign dividends are fully taxable, holding them in tax-sheltered accounts still makes sense. Trying to avoid a relatively small foreign withholding tax while ignoring Canadian income tax is penny wise and pound foolish.
■ Real estate investment trusts. REITs hold property like office towers, apartment buildings, shopping centres and hotels. They pass along most of their cash flow to investors, making them attractive to income-oriented investors. Unfortunately, REITs are not very tax-efficient.
Some of their payouts are considered “other income,” which is fully taxable and not eligible for the dividend tax credit. Much of the rest comes in the form of capital gains distributions and return of capital. (Your tax slips will indicate the exact income breakdown.) While return of capital is not taxable—it’s just your money being returned to you—it causes your adjusted cost base to fall. The lower the cost base, the higher your realized capital gain will be when you eventually sell the REIT.
If you invest in U.S. or international REITs through ETFs or mutual funds the tax situation is even worse. The income is subject to foreign withholding taxes and all the rest is fully taxable at your top rate. Bottom line: REITs should be kept in tax-sheltered accounts whenever possible.
How much tax would you have paid?
We’ve explained which asset classes are most and least tax-efficient, but how about some real numbers? We asked Justin Bender, portfolio manager at PWL Capital in Toronto, to estimate the total amount of tax payable by someone who invested in each of the major asset classes over the last five years.
Bender assumed an investor purchased $10,000 worth of each of several ETFs on December 31, 2007. Then he tracked the income generated by these funds from 2008 through 2012, including interest, Canadian and foreign dividends and capital gains distributions. Finally, he estimated the taxes payable on that income using 2013 rates for the highest Ontario tax bracket. (Its rates are about average.)
Note these numbers include taxes on income only. We’ve ignored any capital gains or losses that might have been realized by investors who sold the ETFs during the five years in question.
Notes: The SPDR Dow Jones Real Estate ETF was launched May 8, 2008. For U.S. funds, the original $10,000 CAD was converted to USD at the prevailing rate on December 31, 2007. Foreign withholding taxes are ignored, since they would have been recoverable with the foreign tax credit.
Putting it all together
Before you plan your asset location strategy, it usually makes sense to consider both spouses’ assets as a single large portfolio, assuming you plan to live off the same retirement assets. Say one spouse has a generous employer pension and little RRSP room: in that case it’s generally fine if that spouse holds more of the equities and the other holds more of the fixed income. This approach can help shelter more of your family’s overall assets from tax, though it does make portfolio rebalancing a bigger challenge. A spreadsheet will definitely come in handy when you’re making your plan.
Remember, asset location should come after the more important decisions, such as the amount of risk you’re taking in your portfolio. If you’re not maxing out all your tax-sheltered accounts, decide whether an RRSP or TFSA makes the most sense for your situation. (In general, those with higher incomes should favour RRSPs.) If you’re using both, hold foreign stocks in the RRSP to avoid withholding taxes. Otherwise the two accounts are largely equivalent when it comes to asset location.
Only after you’ve run out of tax-sheltered contribution room should you use non-registered accounts. Assuming your portfolio holds all the asset classes listed below, place them in your non-registered account using this order of preference. (If your investment plan doesn’t include one of these asset classes, just move to the next one in the list: never choose an investment solely for its tax characteristics.)
These are guidelines only. Determining optimal asset location for a large portfolio with many accounts is a complicated task: a qualified financial adviser or accountant can definitely help in this department.
Preet Banerjee is an award-winning personal finance commentator and former adviser. You can follow him on Twitter at @preetbanerjee and subscribe to his personal finance podcast, Mostly Money, Mostly Canadian, on iTunes.