Tax Efficient Investing by Account Type

Edited Photo. Source: Flickr - Bernard Spragg

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

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.

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

What Asset Class Goes 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 higher yield dividend paying stocks.
  • Avoid highly volatile products as you cannot take advantage of losses.

RRSP: 

  • Use for high growth products, especially when starting out.
  • Use for lower growth products 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. I repeat: To benefit from this, U.S. stocks/ETFs must be purchased on U.S. stock exchanges!!
  • 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.

Cash/Margin:

  • Use for all investments after optimizing TFSA and RRSP accounts.
  • Use for Canadian stocks/ETFs with dividends.
  • Use for swap-based ETF products which convert all distribution returns to deferred capital gains.
  • Use for foreign stocks/ETFs which are high capital growth and low dividend yields.
  • Use for volatile products to realize capital losses which can be carried forward indefinitely. Be careful when purchasing back within the sector to use a similar, but distinctly different product. For example, if selling XGD.TO (S&P/TSX Global Gold Index) at a loss, you can buy the similar ZGD.TO (S&P/TSX Equal Weight Global Gold Index) instead. These products will perform very similarly, but are still distinctly different.
  • Use for Return of Capital products when retired, or close to retirement. For example, Canadian REITs and other Income Trusts.
  • Use for Canadian preferred shares when retired.
  • Avoid foreign higher yield dividend stocks, especially in your accumulation years.
  • Avoid high yield bond products as all your interest gains will be fully taxed as regular income.
  • Avoid buying/selling or moving products as realized, taxable gains will be triggered each time. Except when locking in capital losses.

RM Balanced Portfolio Example

I will use the asset mix of the RM Balanced Portfolio as an illustration. It's important to note the RM Balanced Portfolio is intentionally designed to be easy to implement and maintain, while providing good overall returns. That's not to say it is superior to anything else.

In fact, somewhat more complex portfolios can have advantages such as cost savings, less volatility, and somewhat higher returns through better capture of rebalancing gains. However, these advantages generally only come into play when you have a large portfolio--well over $500,000.

The Balanced Portfolio has just 4 component ETFs: an All-World Index, a Canadian Index, a Canadian Bond Index, and a Global Gold Index. 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:

  • 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. You may put Canadian stocks here in other scenarios, but I'll explain that another time.

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.

This is a great place for XGD.TO which is typically quite volatile. If it happens to drop substantially (more than 10%), you can always sell it crystallizing your capital loss and purchase ZGD.TO--a slightly different ETF.

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.

Thanks for reading. Come back next week for another Net Worth Update and RM Balanced Portfolio update.

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