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Tax Optimizing the Couch Potato Portfolio

I received an email from a reader questioning how to properly setup the Couch Potato Portfolio for maximum tax efficiency.  I have written about this topic before in my tax optimized portfolio allocation article, but I neglected to name specific examples.

What is the couch potato portfolio?  It’s a simplified index investing strategy that composes of 4 investments.  The 4 parts are made of a Canadian index, US index, International index and a Bond index.  To keep it extremely simplified, you have the option of keeping every investment in equal proportions.  To me, the bond allocation should be adjusted based on your risk tolerance – the higher your risk tolerance the lower bond allocation and vice versa. After the bond allocation is chosen, the remaining equities are divided equally.  At least that’s how I do it.

As index investing can be with mutual funds or ETFs (or a combination), a good example of a low cost mutual fund couch potato portfolio would be with the TD e-Series funds.  For arguments sake, lets assume a 40% TD-e bond index allocation, which means 20% would be the TD-e Canadian Index, 20% TD-e US Index, and 20% TD-e International Index.  If ETFs are your fancy, then a low cost ETF portfolio would be 20% XIU, 20% VTI, 20%, 10% VEA, 10% VWO, and 40% XSB.

What is porfolio allocation?  It’s how to optimally place various types of investments for the highest tax benefit.  For example, foreign dividends may face a withholding tax depending on which account it is held in.

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

As I mentioned above, if you have the contribution room in tax sheltered accounts (RRSP/TFSA), then it’s most tax efficient to keep your investments in those accounts.  However, if you decide to use your TFSA, then keep the foreign holdings (ie. US/international equities) within an RRSP as foreign dividends will face withholding tax (15%) in a TFSA.

However, if you don’t have the contribution room, then simply follow the guideline quoted above.  Here are some specific examples on tax efficient accounts to place your couch potato components:

RRSP:

  • Fixed Income/Bonds/GIC’s – TD-e Bond Index, iShares Short Term Bond Index (XSB)
  • Foreign Equities – TD-e International Index, Vanguard Total Stock Market (VTI), Vanguard Europe Pacific (VEA), Vanguard Emerging Markets (VWO)
  • Canadian Equities – TD-e Canadian Index, iShares Canadian Index (XIU)

TFSA

  • Fixed Income/Bonds/GIC’s – TD-e Bond Index, iShares Short Term Bond Index (XSB)
  • Canadian Equities – TD-e Canadian Index, iShares Canadian Index (XIU)

Non-Registered:

  • Canadian Equities – TD-e Canadian Index, iShares Canadian Index (XIU)

Not to beat this topic to death, but assuming that you use your tax refund wisely, simply keep everything in your RRSP.  If your savings exceed your contribution room, then move some of the fixed income or Canadian equities to your TFSA.  If you don’t have enough room in your TFSA, then move your Canadian Index to your non-registered account.







26 Comments, Comment or Ping

  1. 1. Maciej

    “However, if you decide to use your TFSA, then keep the foreign holdings (ie. US/international equities) within an RRSP as foreign dividends will face withholding tax (15%) in a TFSA.”

    I was under the impression that international equities will face withholding taxes in any account, and that only US withholding taxes can be avoided and only in an RRSP.

  2. Maciej, it depends on the agreement Canada has with that country. I’ll try and get a list of countries where there is an agreement in place.

  3. 3. Brian

    Thanks FT, this was a very straight forward read. Should help alot of readers out there.

  4. 4. cash back credit cards

    This is very interesting information. The idea behind this one is very interested. It would also be very interested to see some actual figure or stats behind a investment strategy such as this.

    Though, a bond index are you seriuos? Why don’t you just buy a lottery ticket instead. Not a big fan of bond index and would really highly suggest switching that one out not matter what your risk tolerance would be. Unless your not wanting to beat out inflation.

  5. 5. JC NewGrad

    Hmm.

    I’m a bit confused about the e-series funds.

    I asked a question a while back on CMF regarding withholding taxes on e-series funds within my TFSA and received this answer:

    “The TD efunds are Canadian-domiciled funds, so there are no withholdings on their distributions to Cdn residents, regardless of where you hold the units … regarding the amounts withheld from the fund by its US-domiciled holdings , you’ll be out of luck … you can’t avoid those withholdings in an RRSP … those amounts are lost to you forever in both TFSA and RRSP.”

    Is this info wrong and should I hold my US/Intl e-series funds in my RRSP only?

  6. Hi JC, the withholding tax depends on the treaty Canada has with that other country. I know that US dividends will not face a withholding tax within an RRSP, but they will in a TFSA. As for the international td fund, I would need to dig a bit further.

  7. Here in the UK I use 3 tax optimising methods.

    Firstly, a portion goes into a Pension which is a tax deferral scheme where I planning to go from 40% tax rate today to 20% at the time I withdraw.

    Secondly, I max out my Individual Savings Account (ISA) which is a tax wrapper where growth and dividends can compound tax free. At retirement these funds can also be withdrawn tax free.

    Thirdly, I buy Index Linked savings Certificates which keep pace with inflation and pay ‘interest’ tax free.

  8. 8. Simon

    I will point out, if you don’t have the money to fill the contribution room of the TFSA, then you are better off putting Canadian equities into the TFSA, rather than in a taxable investment account.

    After all, even though they may have favourable tax treatment for Canadians, paying no taxes is even better.

    For example, for myself, I’ve only been investing for a couple of years. So I dumped all my Canadian equities into my TFSA from my investment account. I have all my US and international equities in my RRSP.

    I am putting about 50/50 mix each year into US and international equities / Canadian equities.

    I’d put more into the TFSA, but I can’t find as many Canadian companies I like as much as US and international companies.

  9. Good reminders Frugal!

  10. 10. Commander T

    JC Newgrad,

    The problem is that the US government does not look through the Mutual fund to the ultimate unitholder when determining who needs to withhold. Therefore US companies must withhold when paying dividends to a Canadian Mutual Fund.

    RRSP’s are only exempt from US withholding taxes when they hold the US investment directly. Therefore the way to set up the couch potato portfolio tax effectively would be to purchase a US ETF in your RRSP. That way the US companies will not have to withhold when paying dividends to the ETF and the ETF will not have to withhold when paying dividends to your RRSP.

  11. Great post, FT!
    I feel like there haven’t been as many “meat and potatoes” posts on MDJ, where you get into lower-level details about how to make something work, as opposed to merely presenting an idea or concept.

    I’ve favourited this post, and will come back to it once I get the finances in order, and create some investing cashflow.

  12. 12. JC NewGrad

    Thanks Commander T.

    So, if I understand corrrectly, until I have sufficient funds to justify the transaction costs associated with purchasing ETFs (rather than e-series funds), it won’t matter if my TD-e US index units are in my TFSA or RRSP — as the dividends will still be taxed (?)

  13. JC,
    The dividends you receive won’t be taxed by the CRA in either account as they are held in tax free/registered accounts. TD already paid the withholding taxes to the IRS on all distributions from the US. Once you have enough money saved up in the TD-e US index, you can buy a US listed ETF as they have a much lower MER. Keep this US listing in the RRSP and not pay any withholding taxes, or keep it in the TFSA and pay the 30% withholding taxes. Fill out the W-8BEN form and have this reduced to 15%. All these reductions in taxes are due to tax treaties between the US and Can.

    Disclaimer: I’m not a financial adviser, just another reader of this and other blogs.

    Good luck.

  14. 14. finance

    Great post there. Like any other it would sometime depends on the agreement between countries. Informative one.

  15. And use this as a time to check for any new tax changes for the current year that could affect any other part of your financial plan.

  16. 16. Rick

    This is the global couch potato actually. The original Moneysense couch contains only 3 funds.

  17. 17. Jug

    So I followed the original Money Sense global couch potato, and put a 40/20/20/20 spit into XBB/XIC/XIN/XSP and its all in my TFSA. Will I be subject to any withholding tax, or not because my XSP and XIN are hedged to Canadian dollars?

  18. Hopefully the admin won’t mind me linking to another financial blog. No disrespect to anyone.

    http://www.canadiancapitalist.com/how-withholding-taxes-affect-the-choice-of-international-investments/

  19. 19. Simon

    This was my email! Thanks a bundle for writing an article about it.

  20. Hey Frugal,

    Good post! (Sorry, I’m late to the commenting party.)

    Question to you and your faithful followers:

    Do you know if RSP LIRAs (Locked-In Retirement Accounts) also have withholding taxes applied to them?

    I can’t find much “out there” on the net about this…

    I would like to hold U.S. dividend-paying stocks in my LIRA (like Johnson & Johnson), but I do not want to be penalized for this by paying any withholding tax.

    I have my RSP LIRA since I had a pension with my former employer.

    Cheers!

  21. @Financial Cents, to my knowledge, RRSP’s are exempt from withholding taxes (US stocks), I would assume that the same rules apply to LIRA’s as well. Might want to double check with a tax pro.

  22. Thanks for the reply Frugal, I will let you know what I find out!

  23. 23. Paul

    I just found this post, and have a simple question.

    How are REITs taxed ? Is it the same as interest ? (ie, no capital gains or dividend breaks…).

    I want to add a REIT or two to my portfolio, and want to optimize my after-tax revenue (especially since I’m just going for some plain indexing and a few dividend stocks)

    PS: Love your blog, very interesting read !

  24. 25. Trevor

    This is a great article! One quick question please. I am putting together a complete couch potato and it only hold 20% Canadian equities (which should go into my non-registered account). However, my investment room is only about 50/50 registered/non-registered.

    What would then be best to move into the non-registered portion – the Canadian bonds? Assuming lowest yield then this would trigger the least capital gains correct? Thank you.

  25. 26. Drew

    What is the optimal allocation when you’re looking to invest at least 50% of your income?

    You max out your RRSP and TFSA contribution quickly and everything else has to go into a taxable account. It’s clear that a TFSA is the best account for bonds, of the three.

    Is it better to put VTI in your RRSP while VXUS and Canadian equity go into a taxable account, or vice versa with VTI and VXUS?

    The US withholding tax portion of both VTI and VXUS is recoverable from taxable accounts. So does it matter which is sheltered and which is taxable? You’ll save the US withholding tax and pay the international portion either way, right?

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