We all talk about diversification and asset allocation, but what about portfolio allocation?  That is, once the diversified investments are chosen, where do I put them?  Basically, portfolio allocation is the most tax efficient way to hold your securities based on the taxation of both the security and the account in the view that all your assets are a giant portfolio instead of multiple sub accounts.

I first thought about this idea with a comment from “Telly” that mentioned that I should look and plan my portfolio as a whole instead of numerous sub accounts. Portfolio allocation was then further reinforced by QCash when he wrote about his million dollar portfolio allocation.

Where do we start?

Lets take a look at various investment instruments and their tax consequences:

• Canadian Dividends – Dividend tax credit makes Canadian dividend income very tax efficient in a taxable account.
• Foreign Dividends – In non-registered accounts, foreign dividends are taxed 100% at your marginal tax rate (ie. if you are in the 40% tax bracket, you will pay $40 in tax for every $100 interest).  In TFSA’s, right now, it seems foreign dividends will face a withholding tax.
• Bonds/GICs/Money Market – In a taxable account, interest is taxed at 100%.
• Income Trusts – Income Trust distribution varies between capital gain, return of capital, interest and dividends.  Due to the typically higher interest content, I keep my income trusts and REITs within a tax sheltered account like an RRSP or TFSA.

For people without a retirement pension, an RRSP or TFSA (or other retirement account) usually provides enough contribution room to create a diversified portfolio.  The power of portfolio allocation kicks in when the RRSP or TFSA is maxed out.  How do you allocate your diversified portfolio so that you reduce your taxes payable?

For people with pensions and minimal RRSP contribution room, it makes sense to maximize your TFSA before starting a non-registered account.

RRSP/Pension->TFSA->Non-Registered

For example, if you are an indexer, a simple portfolio may consist of globally diversified index funds/ETFs, bonds and cash.  Here are some possibilities on how to minimize your investment taxation providing that your tax sheltered accounts are maxed out:

RRSP:

• Fixed Income/Bonds/GIC’s
• Foreign Equities
• Income Trusts
• REITs

TFSA

• Fixed Income/Bonds/GIC’s
• Income Trusts
• REITs

Non-Registered:

• Canadian equities

My current investment accounts are a bit of a mess but generally tax efficient. All my fixed income and foreign content is under my RRSP and my Canadian dividend portfolio is taxable.  I am in the process of opening my TFSA and will be investing in Canadian REITs for the tax free distribution along with exposure to the commercial real estate market.

Final Thoughts

In conclusion, it usually makes sense to maximize your non-taxable investment accounts before moving into taxable accounts.  However, if you save more than your tax sheltered accounts will allow, you may want to shuffle around your investment assets to minimize taxation where possible.  One strategy that I didn’t throw into the mix is paying down your mortgage.  Although this is debatable, I personally look to pay down the mortgage after tax sheltered accounts are maximized.

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