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.
What about the coming decade?
While it would have been preferable to hold bonds in an RRSP during the last decade, we can’t draw any sweeping conclusions from our findings. Bond yields are much lower today than they were in 2003, and the situation might have changed. Going forward, is holding bonds in an RRSP still the right asset location strategy?
Again, no one can know this in advance. But investors need to make a decision, and we believe it still makes sense to follow the conventional wisdom and keep bonds in an RRSP and equities (when necessary) in a taxable account. The discussion section at the end of the paper explains our reasoning in detail, but here are the main arguments:
- Deferred capital gains on equities can be realized at a lower tax rate. In our analysis, we assumed the investor realized all capital gains at the end of the 10-year period and paid taxes at 23.20%. In real life an investor with significant capital gains from equities would be able realize them gradually in retirement, likely at a lower rate.
- Lower mandatory RRIF withdrawals. If holding high-growth stocks in an RRSP defers more taxes today, the investor would also end up retiring with a larger registered account. Minimum RRIF withdrawals would therefore be higher, which could result in significantly larger tax bills during retirement and potentially a clawback of Old Age Security benefits.
- Premium bonds are particularly tax-inefficient. The period we examined would actually have been a relatively good time to hold bonds in a non-registered account. Bond ETFs today are far more likely to hold premium bonds, which are exceptionally tax-inefficient and should generally not be held in non-registered accounts.
- New contributions would reduce capital gains. Our analysis assumed no new contributions to the portfolio. In reality, investors in the accumulation phase regularly add to their accounts, and this new cash could be used to top up underweight asset classes. That would reduce the need to sell assets when rebalancing, thereby reducing realized capital gains.
- Tax loss selling can further defer capital gains. A disciplined tax loss selling strategy (which we did not include in our analysis) would likely have deferred at least a portion of the capital gains on the equity ETFs in the taxable account. Opportunities for tax loss selling with bonds ETFs are limited.
- Foreign withholding taxes may be lost in an RRSP. If you hold US and international equities through Canadian-listed ETFs, you face an additional drag from foreign withholding taxes on dividends. You can reduce or avoid these in an RRSP by using US-listed ETFs, but the cost of converting your Canadian dollars to US dollars can be high.