Tax Efficient Investing by Account Type

When you decide on your asset mix and investment strategy, your primary focus should be your tolerance for volatility, expectation for returns, and ease of implementation. These important factors do not change by account type; they do change by your income, the size of your monthly contributions, your investment timeline, your experience investing, and how far away you are from retirement.

Generally speaking, all of your accounts should be treated as one big portfolio. Then, based on the desired asset mix, allocate a particular asset type to each account as most appropriate giving consideration to taxes and risk. Tax optimization is easier to manage and more straightforward for buy-and-hold strategies than for more active investment strategies.

Always remember: good investing first, tax optimization second. Don't let the tax tail wag the investing dog.

What Assets Go Where

Investment Account Rules of Thumb

TFSA: 

  • Use for high growth products only.
  • Use for Stocks/ETFs such as US Index, Canadian Index, International Index, Emerging Markets Index.
  • Use for Canadian REITs in more complex portfolios, especially when far away from retirement.
  • Good place to buy/sell and move products and allocation around as you don't pay taxes ever.
  • Avoid bonds as they are low growth.
  • Avoid foreign high-yield dividend stocks.
  • Avoid highly volatile products as you cannot take advantage of losses, or contribute to the account in excess of contribution limits.

RRSP: 

  • Use for high growth investments, especially when starting out.
  • Use for lower growth investments if RRSP accounts get too large.
  • Use for U.S. stocks/ETFs which pay dividends as U.S. taxes are not withheld on dividends from U.S. stocks when held in an RRSP. If you have more than $100,000, consider converting to a U.S. dollar RRSP buy on the U.S. exchanges. To benefit from this, U.S. stocks/ETFs must be purchased on U.S. stock exchanges with USD accounts!!
  • Use for high-yield corporate bonds.
  • Good place to buy/sell and move products and allocation around as taxes are not paid until you actually withdraw from the account.
  • Avoid tax-advantaged products such as Canadian dividend payers and Return of Capital products when retired.
  • Avoid highly volatile products as you cannot take advantage of losses, or contribute to the account in excess of contribution limits.

Non-registered (Cash/Margin) Accounts:

  • Use for all investments after optimizing TFSA and RRSP accounts.
  • Use for Canadian stocks/ETFs with dividends if lower income.
  • Use for swap-based ETF products which convert all distribution returns to deferred capital gains, especially when high income.
  • Use for foreign stocks/ETFs which have high capital growth and low dividend yields.
  • Use for volatile products to realize capital losses which can be carried forward indefinitely. Be careful to make sure you don't trigger superficial loss rules.
  • Use for Return of Capital products when retired, or close to retirement. Canadian REITs and other Income Trusts.
  • Use for Canadian preferred shares when retired.
  • Avoid foreign high-yield dividend stocks, especially in your accumulation years.
  • Avoid high-yield bond products as all your interest gains will be fully taxed.
  • Avoid buying/selling or moving products as realized gains will be taxed each time. Except when locking in capital losses.

Balanced Portfolio Example

I will use the asset mix of the Growth Portfolio with individual ETF components as an illustration. It's important to note the Growth Portfolio is intentionally designed to be easy to implement and maintain, while providing decent long-term returns. More complex portfolios can have advantages such as cost savings, less volatility, and somewhat higher returns through better capture of re-balancing gains. However, these advantages generally only come into play when you have a large portfolio (over $500,000).

The Growth Portfolio has just 4 components: an All-World Index ETF, a Canadian Index ETF, a Canadian Bond Index ETF, and a Global Gold Index ETF.

What ETF should you hold in each account if your combined investments are $250,000? You have $70,000 in your TFSA, $100,000 in your RRSP, $80,000 in your Cash/Margin account.

We know that XAW.TO holds foreign stock which pays a small dividend (1.55% currently). These are foreign dividends so they are fully taxed as regular income. HXT.TO doesn't pay dividends, but XIC.TO does. Choosing the right one depends on your income level more than anything else: high income use HXT.TO, lower income use XIC.TO. HBB.TO doesn't pay distributions. XGD.TO pays virtually no dividends, but when it does they are partially Canadian dividends and partially foreign dividends.

To meet our desired asset mix, we need to invest the following amounts in each ETF across the entire portfolio:

  • XAW.TO $150,000 (60%)
  • HXT.TO/XIC.TO $50,000 (20%)
  • HBB.TO $25,000 (10%)
  • XGD.TO $25,000 (10%)

TFSA: $70,000 in XAW.TO

We want our highest growth assets here because the gains are never taxed again. Our highest growth ETFs are XAW.TO and HXT.TO. Considering we don't want to pay full income tax on foreign dividends shrinking our returns, it's best to fill your TFSA with XAW.TO in our example.

RRSP: $80,000 in XAW.TO and $20,000 in HXT.TO/XIC.TO

We are currently still growing our RRSP account and it's certainly not too big. For these reasons, we are going to put the remainder of our XAW.TO and some of our HXT.TO/XIC.TO in here.

Cash/Margin: $30,000 in HXT.TO/XIC.TO and $25,000 in HBB.TO and $25,000 in XGD.TO

The Cash/Margin account is a great place for Canadian dividends (if you're in lower tax brackets), swap-based products, and volatile commodity based products. We'll put the remainder of our Canadian stocks here. HXT.TO for high earners, XIC.TO for lower earners.

XGD.TO is typically quite volatile. If it happens to drop substantially (more than 10%), you can always sell it to realize your capital loss and purchase ZGD.TO—a slightly different ETF. When in a Cash/Margin account, realized capital losses can be used to offset capital gains now, or in the future.

HBB.TO is a great bond product for Cash/Margin accounts because bonds are lower growth products and and this ETF converts high-tax interest income into low-tax deferred capital gains income.

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The Smith Manoeuvre: Risks and Benefits

Leveraged Investing Risks

The Smith Manoeuvre is a form of leveraged investing. When using leverage, the upside potential and the relative size of the drawdowns on your equity increases.

Most opportunities for leveraged investing come in the form of margin loans. Margin loans are provided by investment brokerages and are secured by the stocks or ETFs that you hold.

Interest rates on margin loans can be quite low (see Interactive Brokers) and are fully tax deductible when the proceeds are invested in ETFs/stocks that pay some form of income.

However, margin loans are also tricky and can wipe you out financially if you are careless.

You must maintain equity in the account that is above the maintenance requirement (generally 30% or 50% of the investment value). If not, you will face a margin call where you must either contribute new funds to the account or your position will be promptly liquidated by the broker.

Smith Manoeuvre Leverage

The Smith Manoeuvre is very different. You borrow money for investing in the form of a HELOC—a callable loan secured against the value of your house. This means it is very unlikely that you would be faced with a margin call event forcing you to liquidate your stocks at a huge loss. However, as with a margin loan, the loan interest on your HELOC is still tax-deductible if it's used to purchase investments which generate some form of income.

You can only borrow up to 65% of the value of your home in a revolving HELOC loan. This means you maintain substantial equity in your house—a nice margin of safety.

Although the downsides are very real, the upside potential shouldn't be ignored. Using any form of loans to purchase investments can be lucrative over the long term. You can purchase much more investment exposure with less of your own cash.

Returns Without SM: Example Scenario

Mr. Smith is a single Ontarian, earns $150,000 each year, and owns a house worth $600,000. It has increased in value in the last few years, so his mortgage is just $300,000 with 20 years left.

Mr. Smith already has a full RRSP and TFSA and can still save an additional $1,000 a month after paying his mortgage. He currently has $50,000 saved in a Cash/Margin account.

Mr. Smith will slowly pay off the mortgage over the next 20 years and contribute the extra $1,000 a month to his $50,000 Cash/Margin account.

Then, after paying off the mortgage, he contributes the full $2,410 a month for the last 5 years to compare over a 25 year period.

In this case, after 25 years Mr. Smith has a fully paid off house with zero loans. He would also have a $1,000,000 investment account if we use a 6% annual return.

Returns with SM: Example Scenario

Mrs. Smith has identical stats to Mr. Smith. She is single, also lives in Ontario, earns $150,000 a year, and lives in a house worth $600,000 with a remaining $300,000 mortgage.

Mrs. Smith wants to save money on taxes and be richer than Mr. Smith (her ex) when she retires in 25 years. She chooses to implement the Smith Manoeuvre.

Mrs. Smith sells the investments worth $50,000 in her Cash/Margin account and immediately uses the money to pay down the mortgage so there's just $250,000 left on the mortgage balance. She goes to RBC, sets up a Homeline HELOC and a Tangerine chequing account.

With a Homeline HELOC, she splits the loan into two accounts: a flexible mortgage with great prepayment terms of $250,000 (her mortgage portion) and a readvanceable, revolving interest-only LOC portion (the investment loan portion).

Right now, Ms. Smith can borrow $140,000 for investing from her HELOC ($600,000 x 65% - $250,000). The interest on her LOC portion is 100% tax deductible, so at her tax rate she gets back 43.41% of the interest paid each year. Every month her investment loan amount goes up by $1,000 plus the principal portion of the mortgage.

Right from the start Mrs. Smith saves around $2,000 a year in taxes which she applies to her home loan and borrows back for investing. She invests in an ETF that pays 2% in dividends each year.

In this scenario, Ms. Smith's mortgage portion of the HELOC will be paid off in less than 7 years! At this time, her investment account, compounding at 6% each year, will be worth $410,000. 

Mrs. Smith now has a tax-deductible HELOC loan of $390,000. This gives her a "paid-off" $600,000 house, plus $20,000 in net investment equity.

With a maximum investment loan of $390,000, Mrs. Smith will save over $5,000 annually in taxes alone. She wisely directs this to her Cash/Margin account to purchase more investments.

In 25 years, Mrs. Smith's investment account is worth a massive $1.81 million. She still has the $390,000 HELOC so her net assets $1.42 million plus the "paid-off" house.

By using the Smith Manoeuvre strategy, Mrs. Smith is 42% wealthier than Mr. Smith 25 years after their separation—even though they both started in the exact same financial position. They have the same income and savings rates throughout the entire 25 year period. The extra $420,000 in wealth didn't cost Mrs. Smith a penny more in cash-flow each month.

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