The conventional wisdom in much of the Canadian financial blogosphere is tilted to holding bonds in your RRSP. However, the logic behind this generalized advice is not as optimized as it should be for an investor who wants to maximize their after-tax wealth.
We know RRSP withdrawals are subject to full rate taxation. By standard financial planning, big RRSPs are a big problem, especially once you hit the age of 71 and mandatory withdrawals kick in (via RRIFs).
Large withdrawals can put you into high tax brackets, sometimes even higher than your working years. In the worst case scenario, they can reduce your seniors benefits such as OAS.
Bottom line, a high embedded tax liability can significantly reduce the real value of your RRSP, and thereby your true wealth.
Unlike RRSPs, TFSA growth is never taxed again, including withdrawals. There should be nothing holding back the investment growth in your TFSA account.
Bonds have historically provided lower returns than stocks. This has led some of the financial industry to promote placement of low growth assets--like bonds--in RRSPs. However, this only makes sense if you only invest in a TFSA and RRSP.
Bond interest is taxed at full rates on top of your other income. For tax efficiency and investment return reasons, you generally want to avoid having lots of interest income in your non-registered investment account.
While I believe you should seek to limit inflexible taxable income at all times, it is especially when you are working and your interest income can be taxed at marginal rates of 40% or higher.
Since many of the most popular bond ETFs generate the vast majority of their returns via distributed interest income, high taxes on this interest can substantially reduce your true bond returns.
Bond Return Realities
If you take a closer look, bond returns are actually much more dynamic than the simple interest income, especially in managed or index bond ETFs.
Bonds not only generate interest income, they also return capital gains (which are taxed at a 50% inclusion rate) and return of capital (which is not taxed per se, but lowers your cost base).
This means bond ETF distributions and overall bond ETF returns can be much more tax efficient than you think.
Thanks to financial innovations, bond ETF structures have evolved to become increasingly tax efficient. Every self-directed investor today has access to low cost bond funds which have these tax efficient features.
In Canada we have swap-based bond ETFs which are super efficient, essentially converting all returns to deferred capital gains.
We also have a discount bond ETF which invests in bonds discounted from their face value. This reduces interest income and increases capital gains (both distributed and deferred).
Further down, we will look at bond returns for several popular ETFs including XBB.TO (a standard bond index ETF), ZDB.TO (a discount bond ETF), and HBB.TO (a swap-based bond ETF).
RRSP Structure vs Non-registered Account Structure
To understand the effects of taxes on this bond allocation question, it is important to review the tax implications of RRSPs compared to non-registered accounts.
RRSPs are first and foremost a tax deferral account. While you make RRSP contributions with "before-tax" money (you claim the contribution amount on your income tax return to reduce your taxable income), you pay full income taxes on RRSP withdrawals.
Apples for apples, after the tax break at your highest marginal tax rates, you can contribute more to your RRSP than any other self-directed account.
If you are in the 40% tax bracket and you have $10,000 cash to contribute to an account, you will actually be able to gross up your RRSP contribution to $16,666 after factoring in the $6,666 you will get back on your tax return the following spring. If you don't have the extra $6,666 to contribute, you can borrow it from your bank via a short-term loan and pay them back once you get your tax refund.
Moose Tip! Plan ahead and complete a T1213 form with the CRA to reduce the taxes withheld from your paycheque.
A second large advantage to RRSPs is you pay no taxes on any investment income or gains held within your RRSP account. You only get taxed when you actually withdraw money from your RRSP.
You can buy and sell securities, realize profits, collect dividends and interest income and pay no tax. RRSPs can be a good place to engage in active, higher return investment strategies as there is no tax drag on your returns.
Finally, RRSPs are recognized as a retirement account with many of Canada's tax treaty partners. The tax treaty arrangements mean that any distribution income from U.S. listed ETFs or stocks will not be subject to U.S. withholding taxes (saving you 30% tax on the distribution amount).
Non-registered Investment Accounts
A non-registered investment account has far fewer benefits which translates to lower contributions and lower returns.
You cannot deduct contributions to these accounts from your income at tax time. Depending on your tax bracket, this effectively reduces your true contribution amount by 30% to 50% compared to your RRSP.
Also, you must pay taxes on any realized income each year. This includes dividends, realized capital gains, return of capital, and interest income. Certain forms of income such as capital gains and Canadian dividends are taxed at lower rates, while capital losses can be used to offset gains.
The tax costs of constantly having to claim this income each year is called the tax drag. In an efficiently invested account, the tax drag will often be 0.5% of your account value. In a poorly managed account it can be much higher.
In the same 40% tax bracket you can only contribute the $10,000 you have in your hands. This means right off the bat, your non-registered account balance is more than one-third smaller than your RRSP would be. If you realize dividend income during the year, it will be taxed at approximately 25%, reducing your investment returns. If you realize some capital gains (profits) on the sale of an asset in any year, you must include half of the profit to be taxed. This would translate to an effective tax rate of around 20% on the profit portion at this income level.
Broad Bond ETF Comparisons
Here are the actual bond returns for three popular bond ETFs with very different tax structures. We used the 2014 to 2018 time period as many bond ETFs are still quite new to the Canadian market.
The indices these ETFs follow are also somewhat different, so part of the difference in the returns is due to the particular index being tracked. For example, XBB.TO holds 35% federal government bonds while HBB.TO holds 42% federal bonds.
Taking a quick look at this chart, you can see that the simplest bond ETF (XBB.TO) has the largest overall pre-tax gain. This is not surprising since ETFs which engage in more transactions or have more complex structures naturally will have somewhat higher fees and management costs.
It should be noted that the management fees have compressed in ZDB.TO and HBB.TO. The return differential between these ETFs and a standard bond ETF is likely to shrink further in the future. Going forward the return difference between XBB.TO and HBB.TO is likely to be under 15 basis points.
We know that, if you only have a RRSP and TFSA account, the RRSP is the better of these two options in which to hold your bond allocation.
Moose Tip! If you hold bonds in your RRSP, choose the cheapest, simplest bond ETFs (XBB.TO, VAB.TO, ZAG.TO, etc.). The interest income will not be taxed.
Tax Comparisons for Non-registered Accounts
Lets take a look at tax liability for these funds should you hold them in a non-registered account, assuming the investor is in the 40% tax bracket.
To keep the numbers simple, we'll assume that the bond holding started at $100,000 in May 2014 and you are selling your holding in June 2018.
Despite the higher pre-tax return of the simple bond funds, the tax advantaged bond ETFs are a much better choice once taxes are factored in.
The swap-based bond ETF (HBB.TO) outperformed the simple bond index ETF by 25% over four years purely due to the compounding effects of tax drag on realized income.
Bonds are for Non-registered Accounts
Given the benefits of tax efficient bond ETFs, it is suddenly very feasible to hold your bonds in your non-registered accounts. After adjusting for tax drag, return metrics, and some other factors, bonds should be held in your non-registered account for maximum post-tax wealth gain.
Since most Canadians will only ever invest in TFSAs and RRSPs, the average Canadian investor with a conventional buy-and-hold portfolio will have their bonds in their RRSP. Of these two registered accounts, it is definitely preferable to put bonds in the RRSP over the TFSA. TFSAs are for unbridled growth assets, not slow growing bonds.
But many Canadians who are aggressively building wealth, myself included, invest a substantial portion of their assets in a non-registered account. Once the TFSA and RRSP accounts are full, non-registered investment accounts are the remaining option for investing in the publicly traded markets.
If you have a RRSP, TFSA, and non-registered investment account, your non-registered account is the best place for your bond ETFs.
This is particularly true if you invest in HBB.TO, the highly tax efficient swap-based ETF from Horizons. Here is the math to demonstrate why:
Dealing With the Large RRSP Issue
Despite common financial wisdom cautioning investors about big RRSPs, an aggressive and savvy investor should make it their goal to maximize the value of all their accounts including their RRSPs.
While a truly massive RRSP is not necessarily an easy thing to deal with from a tax perspective, don't be fooled into thinking you will automatically be stuck with a large tax bill that is so damaging you should have avoided large returns within your RRSP.
You can withdraw money from your RRSP and still be tax efficient. With some planning, you should be able to get money out of your RRSP nearly tax free.
The issue of RRSP size/tax liability is actually something I've changed my own mind on as I have learned more about aggressive (and still legal) tax planning.
For example, an aggressive tax planner can use several tactics to reduce their taxes on RRSP withdrawals in retirement. The main strategy would be creating interest expenses to offset your income.
The most aggressive way to do this is using your RRSP to borrow against your house for investing purposes. You may be able to withdraw tens of thousands each year from your RRSP completely tax free while technically remaining debt-free.
You can also reduce taxes on your investment profits in your non-registered account by strategically harvesting capital gains to increase the adjusted cost base of your investments. This strategy can help you pay no taxes at all on your swap-based bond ETF, even when selling ETF units for a profit.
Don't be fooled by conventional planning tax fears. More money in your RRSP gives you more options. Better tax planning increases your overall net wealth. For these reasons, use your RRSP to buy growth assets like stocks (particularly foreign listed stocks) and worry about the tax issues on withdrawals later. Put your bonds in your non-registered investment account, but make sure you buy one of the more tax efficient bond ETFs to increase the true returns your bonds can provide.
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