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Asset Location: Tax Savings Through More Organized Living

August 22, 2017 - 20 comments

Among the most common questions I receive from blog readers is: “How do I tax-efficiently manage an ETF portfolio across various account types?” This question relates to asset location – or which asset classes should end up in which accounts. This is not to be confused with asset allocation, which is how much of your portfolio to allocate to each asset class.

If that’s still a little confusing, think of the assets in your portfolio as being like the hours in your day. You may allocate eight hours each to working, playing and resting. You’ll also locate each hour in a place most appropriate for the activity – such as a dark, quiet room when it’s time to sleep. Similarly, you may allocate 40% of your assets to fixed income and 60% to equity, but you’ll locate these holdings where you’ll get the most tax-efficient bang for the buck.

Big picture, that means you want to consider the tax efficiency of each type of holding, based on its potentially taxable annual interest or dividends, as well as its potentially taxable eventual capital growth through the years. (At least we hope your holdings grow!) You then locate each holding where both types of tax ramifications are expected to cause the least overall damage done.  

So how does that work?

First, a few ground rules. In the scenarios that follow, I’ll assume a 40% fixed income/60% equity asset allocation. Since most investors are managing a similarly balanced/rebalanced portfolio, this practical model strikes me as a happy medium between ignoring the potential tax-saving benefits of asset location, versus taking the calculations to an extreme.

If you really wanted to sharpen your pencil, some might suggest using the less-traditional, but more complex after-tax approach for calculating optimal asset locations. Since asset location is always a best-estimate effort (with THE best answer only available in hindsight), it seems to me that the law of diminishing returns begins to apply.

Let’s get started!

Scenario 1: All assets in RRSP accounts

This is the most basic situation. Obviously, if you only have one type of location in which to invest your assets, your choice of location is pretty easy. It’s like living in a one-room house. The only way to make the portfolio slightly more tax-efficient is to swap out the Canadian-listed foreign equity ETFs for their US-listed counterparts (using Norbert’s gambit to convert your loonies to dollars).

Scenario 2: Assets are split between TFSA and RRSP accounts

In this situation, you and your spouse have assets in both TFSA and RRSP accounts. As all growth and dividends that accumulate in a TFSA account are never taxed (even upon withdrawal), investments with the highest expected returns should be held here first.

That makes equities the obvious choice for the TFSA account. Unfortunately, we have no idea which equity region will outperform moving forward. As a personal preference, I choose to hold Canadian, U.S., and international/emerging markets equities evenly, to mitigate my regret if I otherwise managed to choose the worst outcome. Feel free to adjust this allocation if you would rather roll the dice.

Don’t bother holding US-listed foreign equity ETFs in your TFSA accounts – this does nothing to mitigate foreign withholding taxes.

Scenario 3: All equities fit into TFSA and taxable accounts

Once you’ve maxed out your TFSAs with equities, your taxable accounts are usually the next best location if you have more equities (since only 50% of capital gains are taxable there). You may also stumble across tax-loss selling opportunities in your taxable accounts, which could help you defer future capital gains taxes when rebalancing your portfolio.

Scenario 4: Fixed income has spilled over into the taxable account

Your portfolio is looking great and you’re on the right track. Just don’t blow it by holding tax-inefficient fixed income products in your taxable account. As I’ve written about in the past, most bond ETFs are not ideal candidates for taxable investing (due to the higher coupon payments of the underlying bonds). The BMO Discount Bond Index ETF (ZDB) attempts to mitigate this issue by investing in lower coupon bonds. As you can see in the chart below, the taxes paid on a $10,000 taxable investment were substantially less for ZDB vs. the BMO Aggregate Bond Index ETF (ZAG).

2016 taxes payable on a $10,000 investment (Ontario taxpayer in the top marginal tax bracket)

Exchange-Traded Fund Asset Class Total Taxes Paid (2016)
BMO Aggregate Bond Index ETF (ZAG) Canadian Bonds $150
BMO Discount Bond Index ETF (ZDB) Canadian Bonds $103

Sources: CDS Innovations Inc. Tax Breakdown Service, BMO ETFs


Scenario 5: RRSP accounts must still hold some equities

What if you can’t fit all of your equities into your TFSA and taxable accounts? Generally, if you must hold some equities in your RRSP accounts, opt for international equities. With their fully taxable and juicy dividend yield of around 3%, the taxes payable each year will take their toll. In the chart below, I’ve shown the taxes paid by an Ontario resident in the top tax bracket during the 2016 tax year for a $10,000 investment in each equity ETF. As you can see, holding international equities resulted in higher taxes payable during the year than any of the other equity regions.

This is also a good example of when it makes sense to build a 5-ETF rather than a 3-ETF portfolio. Holding a global equity ETF (such as the iShares Core MSCI All Country World ex Canada Index ETF (XAW)) would not allow you to isolate the less-tax-efficient international equities, so you could locate them within your RRSP account. Breaking up the ETF into its underlying U.S., international and emerging markets components provides more flexibility in this situation.

Depending on where you live in Canada (and your actual tax rate), prioritizing the asset location order for remaining equity asset classes could differ from the results below. Next week, we’ll take a closer look at that.

2016 taxes payable on a $10,000 investment (Ontario taxpayer in the top marginal tax bracket)

Exchange-Traded Fund Asset Class Total Taxes Paid (2016)
Vanguard FTSE Canada All Cap Index ETF (VCN) Canadian Equities $109
iShares Core S&P U.S. Total Market Index ETF (XUU) U.S. Equities $103
iShares Core MSCI EAFE IMI Index ETF (XEF) International Equities $146
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) Emerging Markets Equities $112

Sources: CDS Innovations Inc. Tax Breakdown Service, BlackRock Canada, Vanguard Canada


By: Justin Bender with 20 comments.
  28/06/2018 12:10:12 PM
Justin Bender
@marc: These are just illustrations made in Excel – I have not posted a calculator online.
  11/05/2018 5:18:50 PM
is this calculator posted anywhere?
  05/02/2018 9:59:42 AM
Justin Bender
@William: I’m considering posting a similar “portfolio planning” spreadsheet to my personal blog, so please keep an eye out for it.
  05/02/2018 9:59:11 AM
Justin Bender
@lo: Most of the same rules of thumb apply, although foreign dividends do not integrate well in a corporate account (so if you can hold them in a personal taxable account, you may want to consider this option):
  18/01/2018 4:03:14 PM
Hi Justin, this has been really helpful.

I was looking for a good spreadsheet to track assets for myself and my significant other as you've laid out here. Is there anyway you can provide a copy of the spreadsheet?

  17/01/2018 5:12:01 PM
Great article! Probably a basic question, but do the same rules for taxable accounts apply to a corporate account? Do you have any reading references about asset location between corp/RRSP/TFSA accounts%
  08/01/2018 2:24:15 PM
Justin Bender
@Lise: I’m glad you liked the asset location articles – best of luck!
  02/01/2018 5:59:14 PM
THANK YOU. This is just what I was looking for. And Melissa Yuan Innes' summary was a great take - home. There is so much info out there and it's so easy to miss something important like asset location.
  02/10/2017 3:49:14 PM
Justin Bender
@Beverley: The asset location decision is not the same as asking whether you should retain earnings within your corporation for investment or distribute dividends/salary to yourself and invest the cash within your TFSA. However, generally, it can be more tax-efficient over the long term to invest in your TFSA rather than your corporate account:
  02/10/2017 6:28:43 AM
Hi Justin
thanks for this blog..I have just paid off my mortgage and want to start saving in my corporate account or my TFSA. It sounds like you think the TFSA is the better starting place?
  27/09/2017 9:30:49 AM
Justin Bender
@Dave D: The taxable account “limit” is based on how much you are able to save in the account once you’ve presumably maxed out your TFSA and RRSP accounts (it’s a personal cash flow limit). Once the TFSA has all equities in it, buy any remaining equity allocation in the taxable account. If you run out of cash in the taxable account, buy any remaining equities in the RRSP account.
  27/09/2017 9:30:20 AM
Justin Bender
@John: If 10% of the portfolio is allocated to bonds, buy bonds in your RRSP first. Equities can then be added to the TFSA, remaining RRSP and taxable accounts (since all of your bond allocation is already being held in the RRSP, everything else will be invested in equities).
  26/09/2017 4:50:38 PM
Justin Bender
@Melissa Yuan Innes: You nailed it – well done! :)
  26/09/2017 4:48:42 PM
Justin Bender
@Justin: If you’re holding equity ETFs within an RRSP account, it’s more tax-efficient to hold US-listed versions of the funds, in order to mitigate the foreign withholding tax drag. If you’re holding equity ETFs in a non-registered account, it’s generally more tax-efficient to avoid high dividend paying ETFs (as you will pay tax each year on the dividends).
  22/09/2017 4:26:44 PM
Hi. This is great information, but I am not quite clear on what you do if you have access to all three account types (TFSA, RRSP and taxable), but will be investing 90% in equities. In this case, the TFSA will be maxed out pretty quickly relative to the RRSP if you put all your equity contributions in the TFSA and your bonds in the RRSP. Where should the excess equity contributions go? Are you suggesting they would still go in the taxable account even though there's lots of room in the RRSP?
  22/09/2017 11:09:56 AM
Dave D
I'm not what you mean are “What if you can’t fit all of your equities into your TFSA and taxable accounts?”. You can always add more to your taxable account - we are only restricted on the TFSA and RRSP. So after filling TFSA, when is it better to place some equities in RRSP, perhaps filling remaining space or perhaps even bumping out bonds, rather than placing remaining equities in Taxable?
  18/09/2017 11:28:08 PM
Melissa Yuan Innes
Justin, this is my favourite of your blogs recently.
I'm a simple woman, so I'd like to sum it up like this:
RRSP only: usual stock/bond split.
RRSP & TFSA: keep the bonds in the RRSP
Taxable accounts: try to avoid bonds, but if you do bonds, buy ZDB instead of ZAG.
Sound reasonable?
Thanks. Keep up the excellent work.
  13/09/2017 2:32:43 PM
Thanks for this article. Never thought about asset location a lot. I am a mid range tax payer in bc, i have put bonds in my tfsa and non reg has equities... for rrsp, would it be better to put those us/european stocks that give out a higher dividend but are slow growth? Or better to put it also in non reg?
  28/08/2017 11:03:17 AM
Justin Bender
@Garth. The tax implications on the current income for Canadian equities and tax-efficient bond ETFs is very similar (so even after accounting for the dividend tax credit, you still pay roughly the same amount of taxes each year in the taxable account whether you hold one or the other).

The benefit of holding Canadian equities in the TFSA account first is the complete avoidance of the capital gains taxes on the growth when the ETF is eventually sold (bond ETFs are not expected to have significant capital gains when you sell them, so holding them in the TFSA account first will be expected to lead to a lower after-tax net worth).
  23/08/2017 4:46:42 PM
Re TFSA's Are you not ignoring the fact that dividends are after(corporate) tax money? Even though you pay no additional tax on withdrawal, you are missing out on being compensated for the corporate tax paid on your behalf through the gross up and dividend tax credit. Fixed income, on the other hand, never gets taxed in a TFSA.

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