How to allocate assets across accounts for tax efficiency

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By Julie Cazzin with Andrew Dobson

Q: How would you recommend allocating assets and rebalancing over a variety of accounts? My wife Rita and I have two tax-free savings accounts (TFSAs), two registered retirement savings plans (RRSPs) and one joint non-registered investment account between us. Tax reasons mean different assets fit best into different accounts, but then I lose the power to rebalance, because I can’t just sell exchange-traded funds (ETFs) in my RRSP to buy ETFs in my wife’s TFSA. Am I missing something? And what’s the best strategy for us going forward into retirement? — Shane and Rita

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FP Answers: Asset location planning, which involves holding investments in accounts based on their tax efficiency, is the strategy that you are describing, Shane and Rita. For many investors, asset location planning is not of significance as it mostly comes into play once someone maxes out their RRSP and TFSA. Since investments held outside of registered accounts are generally taxable, there can be tax savings to consider in how best to allocate them. The question is whether it’s worth it.

First, if you invest in Canadian stocks that pay dividends, these are more tax efficient than holding non-Canadian stocks paying dividends in a taxable non-registered account. When sold, these stocks have a capital gains inclusion rate of only 50 per cent on the first $250,000 of gains in any given year. You can also claim a capital loss if you sell a stock in a loss position, to be deducted against current, future, or even past capital gains — a benefit not available in registered accounts.

The unique feature of Canadian dividend paying stocks is that they qualify for the dividend tax credit. The credit is valuable, as it allows you to receive a significant amount of income at lower effective rates. For example, in Ontario, an individual could receive about $50,000 of eligible dividends, and if they have no other income, would not have to pay tax on this income due to the tax credit. Capital gains income is also more flexible than ongoing income, like dividend and interest payments, as gains can be deferred and there is more control on the timing of the income as a result.

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Canadian dividend paying stocks are also efficient in a TFSA, though, as any income they produce in the form of dividends or in realized capital gains on disposition are not taxable so long as they are held in the account. So, Canadian stocks are truly tax-free in a TFSA. Foreign dividends paid by U.S. and international companies will have unrecoverable withholding tax, as there are no formal treaties with other jurisdictions to recognize the TFSA as a tax shelter. As a result, U.S. and foreign stocks are never completely tax-free in a TFSA. You need to concede 15 to 25 per cent withholding tax on the dividends earned that gets withheld by your brokerage.

Interest income and U.S. dividends are most tax efficient in an RRSP. These two sources of income are highly taxed in non-registered accounts, as income from interest payments or U.S. dividends are taxed as full income with no tax preference. RRSP accounts are tax exempt from withholding tax on U.S. dividends received in the accounts, so U.S. stocks can be more tax efficient in an RRSP than in a TFSA.

One point of clarification is that, if you own your U.S. stocks through a Canadian fund like a mutual fund or ETF, there will be withholding tax of 15 per cent on the dividends, regardless of which account they are held in by you. In a non-registered account, you can claim a foreign tax credit that reduces your Canadian tax owing, thus avoiding double taxation. In RRSP or TFSA accounts, there is no recovery of that tax.

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Though asset location investing may provide benefits in terms of tax efficiency, asset allocation — which is the process of allocating assets to investments such as cash, bonds, or stocks — should be of more significant importance. For example, just because Canadian stocks pay tax-preferred dividends, it does not mean that you should only hold Canadian stocks for equity exposure. If you were to invest this way, you may find that the tax benefits are great but that their returns are lower or volatility is higher due to a lack of diversification.

You may be able to get better tax treatment on a Canadian dividend than a U.S. dividend, but the U.S. stock may be a more compelling investment, as it could have higher upside potential on the capital growth side. Additionally, determining what proportion of each asset class should be held in each account may be a challenging exercise to track, especially if you are regularly contributing or withdrawing from an account.

The timing of withdrawals may not support an asset location strategy, either. If you were planning to withdraw funds from your non-registered accounts in your early years of retirement and implemented an asset location strategy holding only Canadian dividend paying stocks in the account, you may be in a position where you are only drawing down risk-on or higher risk, assets like Canadian stocks while leaving fixed income in your RRSP to grow at likely a slower pace than stocks. What if Canadian stocks significantly underperform during your eafrly draw-down years?

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Finally, the complexity involved in asset location strategies can be time consuming. For many investors who purchase managed products like asset allocation mutual funds and ETFs, a tax location strategy could be a complexity for their investment portfolio. An investor could end up spending a significant amount of time balancing and could also make mistakes in the process. Keep in mind that the tax savings that you may benefit from in implementing this strategy may not be worth the time or effort — especially if you are not a highly motivated or well-versed investor and managing your own portfolio. It may be something your investment advisor can do to a limited extent, so talk to them about it and get their take, too.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.

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