Taxable investors have it tough: not only must they determine the right mix between stocks and bonds (their asset allocation), they must also choose the right account to hold each security (their asset location). If they choose poorly, they will end up paying a lot of unnecessary tax.
To illustrate, let’s construct a $1 million portfolio, with $400,000 in a non-registered account and $600,000 in a registered account. The overall asset mix is 40% bond ETFs and 60% stock ETFs:
We’ll assume the portfolio is implemented at the start of 2012, and for simplicity, we’ll also assume par for the CAD/USD exchange rate. Then we’ll compare the taxes that would have been payable by an Ontario investor in the highest marginal tax bracket who implemented portfolios with “ugly,” “bad” and “good” asset locations.
When looking at the portfolios of prospective clients these days, I witness this ill-fated asset location decision a lot. The investor’s reasoning is always the same: “My advisor told me that since interest rates are so low, it no longer makes sense to hold bonds in my registered accounts, because the tax savings would be so small compared with equities.”
This is complete nonsense. In the example below, an investor in the highest marginal tax bracket using this strategy would have paid $6,388 in taxes in 2012:
This is one of the most common mistakes investors make: each account has the exact same asset allocation. Most investors are stunned to find out just how inefficient this is: “This is the way I’ve always been doing it. Does it really make a difference?”
In the example below, the investor in the highest marginal tax bracket would have paid $5,340 in taxes in 2012—a slight improvement over the ugly asset location, but still far more than necessary.
If you want to minimize taxes, start by filling up your registered accounts with your bonds. Then add international equities, since these currently have a higher dividend yield than U.S. equities. In the non-registered account, Canadian equities should be held first so you can receive the generous dividend tax credit. U.S. equities should be next, as they have a relatively low dividend yield (remember, foreign dividends are fully taxable).
By locating assets in this manner, the investor would have reduced their taxes to only $3,660 in 2012. Remember, this is the exact same portfolio: the only difference is the investor’s decision about where to hold each ETF.
In terms of advisors adding value for their clients, this is a no-brainer. In the example above, an advisor could have saved the client between $1,680 and $2,728 in unnecessary taxes simply by efficiently allocating assets within the same portfolio.