Growth Portfolios built with ETFs look a bit different from the Retirement Portfolios discussed last week. Since we invest keeping growth in mind throughout our working lives, as intended in the Growth Portfolios' design, how do we make the transition to a Retirement Portfolio?
You want to think about this transition well ahead of time to be tax smart and prepare yourself financially and emotionally for retirement.
To avoid getting whacked with taxes, you should avoid selling any investments in your Cash/Margin accounts. Try to fund your desired portfolio with new savings and existing dividend/distribution income.
Target Savings to the Portfolio You Want
The first step is to assess your own assets currently and pick the Retirement Portfolio that you want to go with. Don't forget that your assets do not just include your portfolio. You should also consider your home, small business, shares in other businesses, or any other investments you may have. Many people sell some (or all) of these assets in retirement and they are often sold with tax advantages built in.
If you plan to significantly downsize your home and sell your small business, you might find yourself paying little to no taxes on these transactions. The realized value might be enough to fund the required components of your target Retirement Portfolio.
Generally, when shifting your portfolio, you will need to buy 10% each of short term bonds (VSB.TO) and preferred shares (ZPR.TO). You may also need to buy corporate bonds (ZIC.TO) and REITs (VRE.TO). This can add up to 40% of your total, and still growing portfolio, which is a substantial amount of money.
If you're not going to free up assets in other areas, you will have to fund these components from your current savings as you approach retirement. Also use your distribution income from current investments. Depending on your savings rate, you will need 5 to 10 years of saving before retirement to purchase to these missing components.
First Steps to Take
I would start with the Cash Cushion, which typically should be held in your Cash/Margin Account. (Remember to open two joint Cash/Margin accounts if needed for tax efficiency.)
Direct all savings to VSB.TO until the Cash Cushion is worth 10% of your total portfolio value. The cushion will come in handy in any bad situation as you approach retirement and the interest income is quite low so it won't substantially impact your taxes.
After the Cash Cushion is built up, you should take a step back and look at your entire account picture. You want to make sure you are tax optimized for retirement as tax savings will reduce your drawdowns and increase your success rate.
Account Type Considerations
You will have a TFSA, probably RRSPs as well, and a Cash/Margin account. You want to make sure that in retirement your Canadian dividend income be realized in your Cash/Margin accounts and interest income in your RRSPs.
Remember you can shift your ETFs within registered accounts without affecting your taxes. Just don't make any account withdrawals!
The next step is building your preferred share allocation with ZPR.TO. Preferred shares should be held in your Cash/Margin accounts as they generate Canadian dividend income.
After this, it is likely you will need to start selling some assets within your TFSA & RRSP accounts. For example, if your Canadian stock ETF (XIC.TO/HXT.TO) is in your RRSP, sell a chunk of it within the account each year. Instead use your new savings to buy XIC.TO (which pays Canadian dividends) in your Cash/Margin accounts. Within the RRSP, buy your 10% corporate bond allocation instead as it generates interest income.
I believe the best place for REIT allocations is in your TFSA accounts. REIT income is a mixed bag of income types which are all taxed differently and come in different proportions from year to year. Approaching retirement, use your new TFSA contributions to buy your desired REIT allocation.
When retiring, you should make your final account shifts to achieve your final desired allocation and make sure the right ETFs are in the right places for tax efficiency.
This means you will be doing some buying and selling within your registered accounts. Use the Tax Guide here to get it right.
- All bonds (except the Cash Cushion) should be in RRSP accounts.
- Canadian dividend paying ETFs should be in Cash/Margin, or TFSA if you don't have a Cash/Margin account.
- Foreign stock ETFs can be in your TFSA or RRSP first. If you need to have them in Cash/Margin accounts consider swap-products.
- If you have a larger RRSP filled with U.S. corporate bonds and your U.S. stock allocation, be smart and switch to a U.S. dollar RRSP and hold VTI (instead of XUU.TO) and VCIT (instead of ZIC.TO) to save on withholding taxes.
Planning ahead and giving yourself plenty of time to make the right moves will make things a lot easier in retirement. For an average couple in retirement with full TFSAs, healthy RRSPs, and Cash/Margin accounts generating Canadian dividend income, your income taxes should be super low.
Investment assets of $1 million generating $40,000 a year split between two people, plus CPP/OAS income, should add up to a total tax bill of less than $5,000 in BC, AB, SK, or ON. That's less than a 10% tax rate when averaged over all income. It can be even $0 with certain account setups.
OAS is really a form of "negative tax" as it's a government benefit which you don't directly contribute to. Although it's a "taxable benefit", often your after-tax OAS income will exceed the taxes on your CPP and investment income! What a fantastic country to grow old in!
If you own a small business, consider working with your CPA and a good financial adviser to plan your shift to retirement well in advance. Proper planning can save you tens of thousands in taxes.