Hands down, asset location is the topic I receive the most questions about from readers, and with good reason. It’s easy to get bogged down in the details and lose sight of the actual target.
Specifically, asset location is about improving your overall portfolio’s tax-efficiency by being deliberate about where you’ll locate your overall stock vs. bond allocations across your various accounts. In other words, what stock/bond ETF mixes will you hold in your TFSAs vs. RRSPs vs. taxable accounts?
To answer this seemingly innocent question, we first need to master the key concepts involved. Then we can build from there.
And, by the way, merely minimizing foreign withholding taxes by holding U.S.-based foreign equity ETFs in your RRSP doesn’t count as asset location. That’s a helpful tax-management technique as well, but that’s more about tax-efficient product selection than actual asset location.
Asset Location “Light”
If you’ve dropped by the blog before, you may recall our 2020 posts on Light, Ludicrous, and Plaid asset location strategies … or basic, moderate, and advanced, if you’re not a Spaceball nerd like me.
Essentially, you can manage asset location the easy way, or the hard way. For 99% of you, I recommend taking the easy way out by simply holding a single asset allocation ETF across all your accounts and calling it a day. It doesn’t get much lighter than that, and it can still be pretty darn tax-efficient!
Still, some of you may want to see what harder ways have to offer, which we’ll discuss in more detail throughout this series.
Key Concept #1: Your RRSP Is a Lot Like a TFSA
To set the stage, if you take one thing away from this series, here it is:
Part of the money you stash in your RRSP isn’t really yours, at least not for asset location purposes. From the moment you put it in there, it helps to think of that part as belonging to the government.
This perspective will help you master what most investors never quite grasp about asset location.
Most investors think of their RRSP as a tax-deferred account. You pay no annual taxes on the earnings. But both your original contributions and any earnings are fully taxable when you withdraw them.
For example, let’s say you’ve contributed $100,000 to your RRSP, and invested it all in stocks earning 6% annually for 10 years. At the end of the 10-year period, your RRSP would be worth $179,085. But assuming a tax rate of 40% on withdrawal, your after-tax RRSP value would be $107,451.
Now, let’s look at this scenario from a slightly different perspective. Rather than seeing your RRSP as a single tax-deferred pile of before- and after-tax money, what if we think of it as two piles?
Pile #1 – Your Money: The first pile is the after-tax portion, where both your contributions and your earnings are tax-free, even on withdrawal. This money is yours, to have, hold, and asset locate as you please.
Pile #2 – Their Money: The second pile is the taxable portion, where both your contributions and earnings will eventually belong to the government. Like a dark star, this money is dead to you from the get-go.
Continuing with our example, since your $100,000 RRSP will eventually be taxed at 40%, your “tax-free” contribution is really only worth $60,000. The 6% annual return on this $60,000 will also be tax-free.
From this perspective, your pile of your $100,000 RRSP is similar to a $60,000 tax-free savings account, earning 6% tax-free returns. The government’s pile is the $40,000 taxable portion, along with its 6% growth. They’re effectively using you as their unpaid portfolio manager.
So, what is each pile worth after earning 6% for 10 years? The $40,000 government portion grows to $71,634, and your $60,000 portion ends up being worth $107,451. If you’ve got a sharp eye, you’ll notice that’s the same, after-tax RRSP figure we calculated in our first, single-pile example.
In other words, whether you think of your money as one big tax-deferred pile, or two separate tax-free + taxable piles, what you get to keep and what eventually goes to the government remains the same. That’s why it’s okay to think of your $100,000 RRSP as really only representing a $60,000 tax-free account for purposes of asset location.
Key Concept #2: Your RRSP Allocations Aren’t What You Think They Are
To recap, here’s what we’ve learned so far:
- The after-tax, “tax-free” portion of your RRSP acts like a TFSA. The initial after-tax value and any growth both accrue to you tax-free.
- The taxable “government-owned” portion of your RRSP and any of its growth is dead to you. It’s just along for the investment ride.
What does this mean to you?
If you figure in the taxable, “government-owned” portion within your asset allocation, you are assuming you own more stocks than you effectively do. In other words, choosing to hold stocks in your RRSP (before holding them in other account types) will make your portfolio’s after-tax asset allocation more conservative than your before-tax asset allocation.
Likewise, choosing to hold bonds in your RRSP (before holding them in other account types) will make your portfolio’s after-tax asset allocation more aggressive than your before-tax asset allocation.
Either way …
By holding stocks (or bonds) in your RRSP, you’ll have less invested in stocks (or bonds) than you may think.
Key Concept #3: What Looks Like Asset Location Is Often Asset Allocation in Disguise
That was the warm-up. Is your brain ready for the main event? As we’ll see in our next examples, deciding whether to first locate stocks in your RRSP or TFSA can impact the after-tax asset allocation of your portfolio. This will also have an impact on your future after-tax portfolio value.
Let’s walk through five asset location scenarios to illustrate. To keep things (relatively) simple, we’ll use just one TFSA and one RRSP, with these assumptions across all five scenarios:
- The initial TFSA value will be $60,000.
- The initial, before-tax RRSP value will be $100,000, and your tax-rate is assumed to be 40%. As we just covered, that means the after-tax value of the RRSP will also be $60,000.
- Once again, our measurement period will be 10 years … with no rebalancing.
- We’ll assume a 6% annual return on your stock ETFs and a 2% annual return on your bonds.
- Last, we’ll target an initial before-tax asset allocation of 50% stocks and 50% bonds
Asset Location Scenario #1: Identical Asset Allocation Across the TFSA and RRSP (aka, “Asset Location Light”)
By far, the most common asset location set-up is to hold the same asset allocation across both your TFSA and RRSP. This ensures your before- and after-tax asset allocations are always equal.
For example, in our RRSP, if we allocate $50,000 before-tax equally to stocks and bonds, the after-tax value for each will be $30,000, calculated as follows:
$50,000 x (1 – 40% tax rate) = $30,000
And because the TFSA is always tax-free, its before and after-tax values will be the same. So, it makes no difference whether we’re viewing this initial portfolio from a before- or after-tax basis. It will always be 50% stocks and 50% bonds.
This Asset Location Light set-up takes the least amount of effort to manage, especially now that commission-free asset allocation ETFs are readily available at many discount brokerages. As I mentioned at the beginning, this means you can simply hold the same asset allocation ETF across all account types, and call it a day.
Now, we’ll let this 50/50 portfolio do its thing for the next 10 years, without even bothering to rebalance it back to its original targets. Check out what happens to the after-tax RRSP value after 10 years:
It’s no coincidence that the after-tax RRSP value drops to the same figure as the before- and after-tax value of the TFSA. Remember, the before-tax RRSP value started at $100,000, and our tax rate is 40%, so its initial after-tax value was $60,000—the same as our initial TFSA value. And since they both have the same after-tax asset allocation, they both grow to the same after-tax portfolio value of $90,295. Once again, the after-tax value of your RRSP behaves just like a TFSA. At the end of the 10 years, they create a combined, after-tax value of $180,591.
Asset Location Scenario #2: Holding Stocks in the TFSA First, with a 50/50 Before-Tax Asset Allocation
In our first, “TFSA first” scenario, we’ll ignore the after-tax asset allocation and focus only on before-tax figures. Since the total before-tax portfolio value is $160,000, we’ll allocate $80,000 to stocks and $80,000 to bonds for our before-tax 50/50 mix. We’ll first allocate as much of our stock allocation as we can to the TFSA, and then allocate any “spillover” to the RRSP.
As we have $60,000 to invest in the TFSA, and $100,000 to invest in the RRSP, we would purchase $60,000 of stocks in the TFSA first, $20,000 of stocks in the RRSP, and $80,000 of bonds in the RRSP. This arrangement will provide our before-tax 50/50 asset mix.
Assuming a 6% annual return on stocks, a 2% return on bonds, and no rebalancing, the TFSA, RRSP and total portfolio would grow to $107,451, $133,337 and $240,787 respectively. But after the RRSP has been taxed at 40%, its value would drop to $80,002, resulting in a total after-tax portfolio value of $187,453. This is higher than the $180,591 after-tax portfolio value from our first example, where we simply held the same asset mix across both accounts.
At first glance, it would seem as if holding stocks in the TFSA first and the RRSP second is a better asset location strategy than holding the same 50/50 mix across both accounts. However, looks can deceive, because, as we proposed as Key Concept #3 above …
It’s actually your after-tax asset allocation—NOT the asset location—that is driving the outcomes.
The portfolio started out with a more aggressive after-tax asset allocation of 60% stocks and 40% bonds. It’s this riskier, after-tax asset allocation that explains the higher after-tax portfolio value after 10 years, not the asset location strategy of holding stocks in the TFSA first.
If you’re a skeptic, here’s how it pencils out. If we adjust our RRSP values downward to account for the 40% government-owned portion of the RRSP, its after-tax stock allocation is only worth $12,000. This is calculated as follows:
$20,000 x (1 – 40% tax rate) = $12,000
We also find that the after-tax bond allocation in the RRSP is only worth $48,000:
$80,000 x (1 – 40% tax rate) = $48,000
So, in the overall after-tax portfolio, we end up with $72,000 invested in stocks and $48,000 invested in bonds … i.e., a 60/40 mix.
Asset Location Scenario #3: Holding Stocks in the TFSA First, with a 50/50 After-Tax Asset Allocation
Still don’t quite believe me? Let’s test the claim by still holding stocks in the TFSA first, but maintaining a 50/50 after-tax asset allocation. To do so, we would start by multiplying the $120,000 after-tax value of the total portfolio by 50%, giving us $60,000. Since we want to hold stocks in the TFSA first, and the cash available in the TFSA is $60,000, the entire TFSA would be made up of stocks. As we don’t need to purchase any additional stocks in the RRSP, we can invest its entire $100,000 into bonds. Remember, since the RRSP will be taxed at 40%, the bonds in the $100,000 before-tax RRSP are only worth $60,000 after-tax, so we now have an after-tax asset allocation of 50% stocks and 50% bonds.
The before-tax percentages on our account statements will obviously look different. The before-tax total portfolio value will be $160,000. The before-tax value of stocks vs. bonds will be $60,000 and $100,000 respectively, resulting in a before-tax asset allocation of 37.5% stocks and 62.5% bonds. Clearly, this is more conservative than a 50/50 asset mix … but that’s from a before-tax perspective.
If we let this more conservative, before-tax portfolio ride for the next 10 years without rebalancing, the TFSA, RRSP, and total portfolio would grow to $107,451, $121,899, and $229,350 respectively. After the RRSP was taxed at 40%, we would find its value would drop to $73,140, resulting in a total after-tax portfolio value of $180,591. This is the exact same after-tax portfolio value from our first example, where we held a 50/50 asset mix in both the TFSA and RRSP accounts.
Voila! Our asset location choices had no bearing on our portfolio outcomes. Once again …
It was the after-tax asset allocation (not the asset location) driving the portfolio returns.
This makes intuitive sense. As we discussed earlier in this video, the government portion of the RRSP never accrues to us, nor does any of its investment growth, so both can be ignored entirely.
Asset Location Scenario #4: Holding Stocks in the RRSP First, with a 50/50 Before-Tax Asset Allocation
Because it’s better to have too much proof than not enough, let’s now swap the account location of the two asset classes, holding stocks in the RRSP first. For this first scenario, we’ll ignore after-tax asset allocation, and simply build a 50/50 before-tax portfolio. If you want to skip the exercise entirely, it’s going to once again demonstrate that it’s your after-tax asset allocation, not your asset location, that impacts the majority of your future after-tax portfolio returns.
Since the total portfolio value is $160,000 before-tax, we’ll again want to allocate $80,000 to stocks and $80,000 to bonds to achieve a 50/50 before-tax asset allocation. This time, we’ll first allocate as many of our stocks as we can to the RRSP.
With $100,000 of cash in the RRSP, and $60,000 in the TFSA, we would purchase $80,000 of stocks in the RRSP first and then $20,000 of bonds. We’d finish by purchasing $60,000 of bonds in the TFSA. This arrangement will provide us with our 50/50 before-tax asset mix.
Again, assuming a 6% annual stock return and a 2% annual bond return with no portfolio rebalancing, the TFSA, RRSP and total portfolio would grow to $73,140, $167,648 and $240,787 respectively. After the RRSP has been taxed at 40%, we would find its value would drop to $100,589, resulting in a total after-tax portfolio value of $173,728. This is lower than the $180,591 after-tax portfolio value from our initial example, where we simply held the same asset mix across both accounts.
But once again, if we adjust our RRSP values downward to account for the 40% government-owned portion of the RRSP, we find our overall, after-tax portfolio has only $48,000 invested in stocks and $72,000 invested in bonds. This results in a more conservative after-tax asset allocation of 40% stocks and 60% bonds. So, once again, we would suggest it’s this less risky, after-tax asset allocation that has resulted in a lower after-tax portfolio value at the end of 10 years—not the specific asset location strategy of holding stocks in the RRSP first.
Asset Location Scenario #5: Holding Stocks in the RRSP First, with a 50/50 After-Tax Asset Allocation
For our final example, we’ll continue holding stocks in the RRSP first but target a 50/50 after-tax asset allocation. To do so, we would start by multiplying the $120,000 after-tax value of the total portfolio by 50%, giving us $60,000. Since we want to hold stocks in the RRSP first, and the cash available in the TFSA is $60,000, the entire TFSA would be made up of bonds. As we don’t need to purchase any additional bonds in the RRSP, we can invest the entire $100,000 of cash into stocks. Remember, since the RRSP will be taxed at 40%, the $100,000 before-tax stock allocation in the RRSP is only worth $60,000 after-tax, so we now have an after-tax asset allocation of 50% stocks and 50% bonds.
The before-tax percentages on our account statements will once again look different. The before-tax total portfolio value will be $160,000. The before-tax value of stocks and bonds will be $100,000 and $60,000 respectively. The result is a before-tax asset allocation of 62.5% stocks and 37.5% bonds, which is more aggressive than a 50/50 asset mix.
If we set this riskier, before-tax portfolio on auto-pilot for the next 10 years, and don’t rebalance, the TFSA, RRSP, and total portfolio would grow to $73,140, $179,085 and $252,224 respectively. After the RRSP has been taxed at 40%, we would find its value would drop to $107,451, resulting in a total after-tax portfolio value of $180,591. This is the exact same after-tax portfolio value from our first example, where we held a 50/50 asset mix in both the TFSA and RRSP accounts. It is also the exact same after-tax portfolio value of the example where we held stocks in the TFSA first but targeted a 50/50 after-tax asset allocation.
Five Scenarios, One Compelling Conclusion
In case I’ve not yet made my point painfully clear, here it is:
First, regardless of the asset location decision, after 10 years, each of our portfolios targeting the same after-tax asset allocation had the exact same after-tax portfolio value: $180,591. So long as the after-tax asset mix of each portfolio was the same, it didn’t matter whether we held the same asset mix across both accounts, or located stocks first in our TFSA or RRSP.
Second, holding stocks in your TFSA first while targeting a 50/50 before-tax asset allocation did result in a higher after-tax portfolio value of $187,453 at the end of our 10-year measurement period. But this was not due to any tax efficiencies. Rather, the portfolio had a more aggressive after-tax asset allocation of 60% stocks and 40% bonds.
Likewise, when we held stocks in our RRSP first, while targeting a 50/50 before-tax asset allocation, we ended up with a lower after-tax portfolio value of $173,728 at the end of our 10-year measurement period. This was again not due to a bad asset location decision. It was simply the result of investing in a more conservative after-tax asset allocation of only 40% stocks and 60% bonds.
The grand conclusion: Your after-tax asset mix drives most of your after-tax returns, not your asset location decision.
If you made it this far, congratulations are in order. These asset location concepts are not easy. Feel free to take a break and re-read this material later.
After that, if it’s still not sticking, that’s okay too. To be a successful investor, you don’t really need to understand this stuff. You can simply opt for Asset Location Light by holding a single asset allocation ETF across all your accounts. You’ll still have one of the best asset location solutions around.
However, by now, you may be wondering whether asset location matters at all. The answer is, yes, it can! But it takes some extra work to make it happen. In our next two posts, we’ll build on today’s key concepts, and provide practical advice on how to implement a Ludicrous or even Plaid Asset Location strategy in your DIY portfolio.
Just how far can we take this asset location stuff? Keep an eye out for our next two posts, and you’ll soon find out for yourself.