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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