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Which Account to Place your Investments for Maximum Tax Efficiency

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 DividendsDividend 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 TrustsIncome 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.







19 Comments, Comment or Ping

  1. 1. DG

    The book Intelligent Portfolio calls the concept “Household Portfolio”.

    You’ve left out RESPs; what sort of investments should go there? I would argue that you should not put highly volatile investments here; there is a risk that your children won’t go to school or won’t use it all… what if high risk investments perform like gang-busters?

    I also like bonds in the TFSA versus RRSP because they can serve as an easily available emergency fund, but maybe the easy availability is a bad thing…

  2. 2. J.

    The decision to prioritize between RRSP and TFSA depends on whether or not you expect to increase your income in the future (thus, higher tax). If the answer is yes, TFSA makes sense, if no, RRSP may be the best (RRSP makes the most sense if you expect your future income to drop.)

    As somebody in the beginning of the career, I plan to fund TFSA first and then RRSP (at least enough to drop my gross to the next tax bracket). Yes, I read all the gloomy news on the weekend, but I don’t need any of my money in RRSP or TFSA for 30-40 years, so my portfolio is quite aggressive.

    RRSP
    - Mutual funds (Mostly in Canadian equity but some bonds + cash equivalents.)

    TFSA
    - 100% Equity (Planned): I’m planning to start with American equities and then add world equities.

    Non-Registered
    - Individual stocks (For the time being, I’m not using this as a serious investment vehicle. I have a fairly insignificant amount of money in here to play around with stocks for learning.)

  3. Bernstein (Four Pillars of Investing) is pretty big on the one portfolio idea. In my opinion it makes sense for similar accounts ie if you have several retirement accounts (2 rrsps, 1 spousal rrsp, pension) then it makes sense to combine them when looking at your asset allocation.

    In theory you can combine your short term accounts (emergency fund, cash in bank) into that portfolio as well but I don’t really see the point. Short term accounts are always going to be cash (or something similar) so combining them with your retirement savings isn’t going to change that.

    RESP is another account that I analyse separately because it has a different timeline than all the other accounts and a different asset allocation.

  4. DG: I consider the RESP as a completely separate portfolio as technically, the money is for my child in 18 or so years. Within that account, I have a diversified index portfolio.

    FP: I’m with you, I don’t count my short term accounts either.

  5. portfolio allocation is not easy topic. nicely written!

  6. 6. James

    DG: I would be interested in seeing what has happened to QCASH’s portfolio since his last update, and what is portfolio allocation is now.
    Maybe you can persuade him for an update.

  7. 7. Sarlock

    I have treated our investment portfolio as one big combined group, allocating funds to each investment slot based on what types of investments are tax favourable. Another thing to note in the above list is capital gains: those are only taxed at 50% if held outside of your RRSP. This is a major advantage. A capital gain in an RRSP, while not taxed at the time it is made, is taxed at 100% of the gain when withdrawn. Unless you expect your tax rate to be signifcantly lower upon retirement when you withdraw your RRSP funds, capital gains are better off made outside your RRSP. Even better, capital gains are not taxed at all inside a TFSA. That makes your TFSA the much better choice to locate any investments that are capital gains focused.

    For my wife and I, our TFSA’s are the place where we hold fixed income securities. This is the “safe” part of our portfolio where the interest income is earned tax free. In a couple of years, once our contribution room grows to a higher percentage of our overall investment portfolio, I will begin investing in capital gains focused investments as well.

    RRSP’s is the place I hold mostly foreign equities.

    Outside, in a taxable investment account, we hold our Canadian dividend earning portfolio. These dividends are taxable each year, but with the dividend tax credit (something you don’t get in your RRSP, you pay full tax upon withdrawal) it makes it advantageous to hold these stocks in a taxable account.

    It ultimately depends on what your tax bracket is now and what you expect your tax bracket to be upon retirement. As I expect my post-retirement income to be comparable to what it is now, I am not maxing out my RRSP (I am focusing on a spousal primarily, as my wife’s income after retirement will be much lower than mine). I also have a fear that our tax rates are going to be much higher than they are now in 10-15 years. We will have a lot of boomers to fund retirement for and a less productive nation (per capita) to fund it with.

  8. 8. Ray

    Portfolio allocation I definitely a very complex topic to understand and with the TFSA this year it only gets harder. Most of how you allocate your portfolio will depend on your personal situation (tax bracket, time, family, future plans). I personally am trying not to fully maximize my RRSP, this is because I am in a low tax bracket and am expecting be in a higher tax bracket in a few years.
    I also may need to withdraw from the investments over the next couple of years, so having it in RRSP right now will be very counter productive, as I will get tax refund on a lower tax bracket and will be taxed at a higher tax bracket.

    TFSA I would mainly hold bonds and non-canadian dividend paying stocks.

    I am getting married this year so there is a lot of unknown factors till we get through the wedding planning.

  9. 9. mjw2005

    Great post FT….Just wondering are you planning on buying a REIT ETF or individual REITS?

  10. 10. wx_junkie

    And further to mjw’s post #9, who (broker) have you decided you will use to purchase income trust units from inside your TFSA?

  11. 11. Remus

    Hi guys

    Regarding “In TFSA’s, right now, it seems foreign dividends will face a withholding tax”. Do you know that is 15% if you filled in that form with your broker or it is 30% regardless.
    Also do you have any idea inside the RSP the withholding tax is 0?

    For instance I use E-trade and part of the account opening process is either a form W8-BEN or a copy of your canadian driving license. With that on file though I would assume the tax should be less meaning just 15% inside the TFSA no? And for RSP 0 foreign tax as I think I’ve read somewhere that the RSP is covered under a tax treaty with the US. Oh yes I was speaking here about US dividends. For other countries I have no clue… for instance how much gets withheld for an Asian dividend.

  12. mjw, wxjunkie: I will most likely be purchasing individual REITS as REI.UN is a large portion of the XRE ETF reit index. I actually haven’t had the chance to open a tfsa yet, but when I do, it will be with Questrade..

  13. mjw2005, I wrote a bit last week about buying the 4 largest REITs, the 0.55% MER is a little steep for such a small index.

    http://canadianfinanceblog.com/2009/02/25/real-estate-investment-trust-reit-portfolio.htm

    I am a fan of having REITs in the TFSA and bonds in the RRSP, since the REITs are likely to grow at a faster rate and then be tax free at retirement. With RRSP room towards retirement and looking to change my portfolio, I would also be able to sell REITs from the TFSA and buy more bonds in an RRSP.

  14. 14. dumdumdum

    When (if) I retire, I would like to have most of my money in a TFSA and just enough in the RRSP so that my monthly withdrawals are well under the basic personal tax exemption (i.e. less than about $850 per month in 2009 dollars), and I can get the Canada pension if it still exists. I’m still sort of young so the TFSA wins.

  15. 15. DAvid

    dumdumdum,
    $5000 per year, even when contributions are indexed for inflation, would likely be about $500,000 in 30 years. (based on 5% growth and 2% inflation)

    For the average Canadian $5000 is about 7% of their income, an RRSP allows contributions of about 18% or about 2.5 time as large an investment. You might find your retirement sorely lacking if you are depending on the income from the TFSA to make up the difference in your retirement income.

    Your plan would have you earning about $4000 per month tax free in 2040 dollars, about equal to living on $2000 / month today, plus of course any other government supported income you may be able to access at that time.

    DAvid

  16. 16. Wealth Manager

    Great thread.

    At this point I’ve opted to look at our family accounts (1 spouse, 2 kids) as 3 categories:
    1. RESP: one family RESP in a self directed account.
    2. Non-Reg/TFSA: two of each, treated as one allocation
    3. RRSP: two accounts, treated as one allocation (just starting to convert to this from years of independent management)

    I would like to get some advice/feedback on how best to approach #3 however. At the moment, we have the exact same stocks/ETFs in each account – hence two buys, two sells for everything. I’ve been thinking about breaking this down (e.g. 3 in one, 3 in the other instead of 6 in each) to minimize trading costs, and easier tracking.

    How best do I break this down? Both accounts are roughly the same size and assuming a simple 50% Canadian equity, 30% Foreign equity and 20% Fixed income allocation (simple illustration), how does one spread this across two accounts? Canadian equity in one and the foreign/bonds in the other? I think rebalancing will be very difficult with this model since I can’t move things between accounts.

    I need to thing more seriously about this – I’m sure many of you have so I’d like to hear what you’ve come up with!

  17. 17. Mark in Nepean

    Hi Everyone,

    Interesting thread. A question for all of you….how many of you hold CDN dividend-paying stocks in your RSP? I would seem to be a good move to hold them inside an RSP (for long-term equity growth) and outside, to take advantage of low taxation…

    Thoughts?

  18. Mark, if you are considering holding dividend stocks for the long term (aka until retirement), the holding them outside your RRSP provides many benefits. First, you get the dividend tax credit, and second, you’ll only be taxed on the capital gains when you sell. Within an RRSP, you’ll pay no tax on the dividends, but you’ll have to pay tax on RRSP withdrawals at your marginal rate.

    As well, depending on your income and province, dividend income outside an RRSP can be extremely tax efficient. For example if you are from Ontario, you can make up to $70k in regular income and only pay around 7% tax on dividend distributions.

  19. 19. Scott

    @DAvid: “For the average Canadian $5000 is about 7% of their income…”

    This is incorrect data.
    That would assume the average Canadian income (net) is over $71,000 per year. It is not.

    The average household income of “Economic families, two people or more” is $71,000 per year.
    ($10,000 TFSA contribution would ~14% of income).

    Average income for “unattached individuals” is just under $30,000 per year. So the $5,000 TFSA contribution is around 16.5% of net income.

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