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The Good, the Bad and the Ugly (of Asset Locations)

May 13, 2013 - 7 comments

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.

The Ugly:

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:

The Bad:

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.

The Good:

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.

By: Justin Bender with 7 comments.
  22/09/2014 10:32:59 AM
Justin Bender
@Diego - unfortunately this is a much more specific question that an investor should obtain personalized advice for.
  11/09/2014 5:34:35 PM
Diego Revere
Hi Justin,
Thank you for this illustration; it is very helpful to see the ideas explained with numbers. I have found your postings and Dan Bartolotti's postings very informative.

If the situation was instead that the investor had $400,000 of RRSP room, but could divide the remaining assets between corporate or personal (taxable) accounts instead, would the advise be to keep bonds (interest generating investments) in the RRSP and everything else in the corporate investment accounts? If you need income information to answer this, then assume the personal marginal tax rate to be the highest bracket (~40%), the corporation actively earns less than $500,000 annually and the investor derives his income from earnings from the corporation.

Thanks in advance.
  22/06/2013 12:10:56 AM
It's great to read something that's both enjoyable and provides parmgatisdc solutions.
  21/05/2013 12:12:59 PM
Justin Bender
@sleepydoc - that would depend on whether you are comparing the taxes payable post-liquidation and post-deregistration. If you didn't assume the RRSP was deregistered, but all investments were sold, then I would agree that there would be realized capital gains taxes to be paid in the non-registered account. Once you assume a deregistration of the RRSPs, the situation would most likely look very different.
  21/05/2013 11:20:53 AM
Thanks. I get the point of this article, but the math works in this example because you are looking at one year with no appreciable capital gains. Even though capital gains are taxed at half the marginal rate and interest income at full rate, over a longer period if you assume capital gains/dividends to average greater than 6%, and interest income at 2%, wouldn't you be saving in tax by sheltering the higher grossing assets. If interest income were higher, obviously this would not be the case
  21/05/2013 9:14:56 AM
Justin Bender
Hi John - I wish I could tell you, but that would depend on tax rates at that time, as well as your own marginal tax rate. If we assume that bonds grow at 2% and equities at 7% (and no change in tax rates), your RRSP would grow much slower than your non-registered account. If this is indeed the case, you would pay non-preferential marginal tax rates on the RRSP portion (which is smaller) and preferential capital gains tax rates on the larger portion (which is larger).
  18/05/2013 8:07:51 PM
Hi Justin
Thanks for your blog which, as usual, is very informative.
Your analysis takes the taxes in year 1 into account. What would be the after tax returns once the portfolio is sold during retirement 10-20 or more years later?

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