An investor’s asset allocation strategy refers to how money is divided across different classes of investments – i.e. stocks, bonds and cash. An asset location strategy, however, drills down a level deeper and deals with “where” or in which accounts to hold your chosen stocks, bonds and cash. Today’s bond yields might prompt some investors to challenge conventional asset location advice.
Traditional Asset Location
Investors fortunate enough to have money to save and invest over and above their RRSP and TFSA contributions need both asset allocation and asset location strategies. The standard advice is to stuff all of the bonds in RRSP, TFSA and similar accounts to defer or shelter tax on interest income (otherwise 100% taxable). Similarly, stocks usually dominate non-registered accounts because they generate more lightly-taxed capital gains and (in the case of Canadian stocks) dividends.
But with bond yields having fallen (i.e. bond prices having risen) in the face of weak stock prices, this traditional asset location advice may not hold for everyone.
Minimize Expected Taxes Payable
Efficient asset location decisions are driven by minimizing taxes payable on investments. But actual taxes can only be confirmed after the fact. Accordingly, we need to make several assumptions to estimate future taxes from investment activities.
Assuming stocks return 8% annually and bonds post returns of 2.36% per year (Canadian bonds’ yield to maturity at the time of writing), bonds might be best held outside of registered plans like RRSPs and TFSAs for higher-income investors. Alternately, those with a five-figure taxable income may want to stick with conventional asset location strategies.
The reason is simply that higher total returns usually result in higher taxes (particularly for higher income individuals). And with bonds sporting razor-thin yields, they don’t stand to generate a heavy tax burden because the pre-tax return potential is so low. In other words, even though the tax rate applied to stock investing is lower compared to bonds, stocks’ higher expected return may result in a higher dollar amount of tax for some. The table below (click to enlarge it) summarizes some calculations and the many assumptions made for this illustration.
Stop, think and assess
Despite the apparent precision, I can’t stress enough that the above table is a very general illustration. For any given situation, the conclusion can swing either way.
For instance, if stocks produce a still-respectable but lower 7% annualized return (or much lower), it will probably make more sense to hold stocks in non-registered accounts. But investors buying only high-yield stocks – a popular strategy today – may save taxes by doing the opposite and keeping that yield in registered plans to defer or shelter the tax.
Investors need to stop, think and assess before blindly following traditional asset location advice. In a general context, the conventional wisdom remains sound. But with low bond yields, it’s worth running through some scenarios to help in this decision. And if you end up holding your bonds outside of registered plans, you might consider one of more tax-friendly bond alternatives available. In what may be a lower-return environment, any return enhancement is worth considering.
Interesting article. I never thought of it this way, although it requires making the decision with assumptions about future stock/bond returns which are, of course, unpredictable.
Does this counsel apply just as equally to mutual funds (for example, I have mutual funds that invest in Canadian bonds, U.S. bonds, Canadian equities, U.S. equities and international equities)?
Let’s say that based on my calculation it makes sense to hold bonds in a non-registered account … would this structure make sense?
Non-registered: Canadian bonds, U.S. bonds.
Registered: Canadian equities, U.S. equities, international equities.
Thanks for your excellent question Bobby. Yes, this line of thinking applies to mutual funds as well as direct stock holdings. Mind you, the more tax efficient you expect your stocks to be, the stronger the case for holding them in NonRegistered accounts. Then again, there’s also a good case for keeping your highest return assets in your TFSA since that account is completely tax free and does not have the restrictions of RRSPs. So you might want to maximize the return/accumulation in the TFSA.
As to your suggested asset location structure, I can’t say for sure if that would be appropriate for you but I am suggesting that this kind of structure may work for some in higher tax brackets. (Note that income generated on foreign investments may be held in registered accounts since this can avoid most non resident witholding taxes.)However, the asset allocation decision depends on so many individual factors that it’s difficult to generalize.
I’m just suggesting we stop ourselves from automatically assuming the traditional advice remains best. It isn’t always.
Appreciate the quick reply, Dan! Good point about the TFSA.
With regards to your point about foreign investments, for mutual funds that invest in foreign bonds or equities, isn’t there an advantage to holding them as non-registered? I might be mistaken, but I thought that I can claim a percentage of the foreign tax paid on distributions with the foreign tax credit, whereas I would lose this credit in a registered account.
If you’re actually holding a US stock, then I agree that you can avoid the withholding tax in an RRSP/RRIF (although not RESP or TFSA).
You’re welcome. Correct on foreign investments. The mutual funds that earn income from non-Canadian sources will have to pay a non-resident tax regardless of where you hold it. The use of the non-resident credit must be weighed against the generally higher taxable income (and hence higher taxes) incurred by holding foreign stocks – particularly if they pay dividends (fully taxable in Canada). But you’re right that the NR withholding tax on a Canadian-based fund can’t be avoided.
Great article.
Although not mentioned in the article, I assume age would be a factor as well. The closer you are to starting cashing registered accounts, the less it would appear to make sense to hold high yielding assets in registered plans,as capital gains and dividends don’t enjoy favorable tax treatment in registered plans and get fully taxed as income when they come out.
In TFSAs, I think dividends always make sense. Capital gains make sense as long as they are gains as capital losses would not be deductible against gains in non-registered plans.
Thank you Marcel. I don’t think age is a major factor – at least not the way I’ve looked at this issue. The reason is that I’ve simply looked at this issue in a way that is focused on minimizing tax. Age only comes into play in the context of age-related tax issues – i.e. clawback of OAS, age credit. But these simply factor into the effective amount of tax and working to minimize that amount. The amount of time a stock (or stock fund/ETF) is held is a material factor as does the types of stocks purchased (i.e. high yield vs. low yield). So age only enters the picture indirectly.
Assuming 8% total returns on equities
Assuming that’s 5% on capital gains, 3% on dividends.
You don’t have to cash in on your capital gains (normally) until you want to thus deferring tax on the 5%.
For frequent trades you may well be correct but I suspect if you buy and hold the benefit would tilt towards equities outside of registered accounts.
Thanks for your comment Martin. You’re right that an individual’s style of investing can totally swing this decision either way. And there are so many different styles; which is why I warned that the table and my assertion will not apply to many people. However, if you read the notes to the table above, it discloses all of my assumptions.
So the 8% return is broken down as 2.13% dividends (the current yield of the S&P/TSX Composite Index) + 2.35% in annual realized capital gains + 3.52% in deferred or unrealized capital gains. In other words, 60% of the capital gains component is deferred. Again, this slices somewhere close to the middle because too many investors trade way too much. But those that are true long-term investors with all of their exposure to stocks (i.e. directly and via funds/ETFs) are less common.
So a 40% annual realization rate implies that stocks are held for 2.5 years on average. But the idea was not to try to set some rule in stone but rather to get people to actually think about this question – rather than assume the answer – and try to put their own styles into context when coming up with a more personalized answer.
Should the chart include where to hold US dividend paying stocks and non dividend paying stocks, etc.