In my last blog post, we determined that the overall post-tax asset allocations in your TFSA and RRSP have a far greater influence on your post-tax portfolio value than the asset location of these various asset classes within your portfolio. In other words, it’s the kinds of investments rather than where you hold them that seems to matter the most between these two venues. I also offered nine different asset location strategies to consider, depending on your investment preferences and circumstances.
Once you’ve maxed out available room in your TFSA and RRSP, you and your money enter the taxable investing universe, where the logistics become even more cosmically confusing.
One of the most common questions I receive from investors is whether it’s more tax-friendly to hold equities in their RRSP or taxable accounts first. Just when you thought you were getting the hang of things! In this comparison, I’m about to demonstrate that your post-tax asset allocation and asset location both determine your post-tax portfolio value – unlike in our TFSA vs. RRSP scenarios.
I’m afraid this concept is also trickier to illustrate. Hang on tight, as I’ve tried to keep the discussion as simple as possible (but not simpler). In the examples that follow, we’ve once again assumed annualized equity returns of 7% and fixed income returns of 3%. At the end of the 10-year period, the full RRSP value is taxed at 20%, while half of the capital gains in the taxable account (i.e., the taxable half) are also taxed at 20%. The portfolios are never rebalanced during the measurement period. Annual rebalancing would certainly impact the ending portfolio values, but not the main concepts.
I’ve also assumed all growth from equities and fixed income in the taxable accounts represent unrealized capital gains. This may seem like a bit of a stretch, but it’s similar to holding a swap-based equity or bond ETF in your taxable account, such as the Horizons CDN Select Universe Bond ETF (HBB) or the Horizons S&P/TSX 60 Index ETF (HXT). It also will make the examples a little easier to follow for those who prefer to break out their financial calculators.
Option #1: Equities in the taxable account first (ignoring post-tax asset allocation)
Pre-tax asset allocation: 50% equities / 50% fixed income
Traditional asset location advice is to hold equities in your taxable accounts first instead of your RRSP. The justification goes something like this: A large portion of equity returns are capital gains (which are taxed at half the rate of most other types of investment income), so it is better to hold them in your taxable accounts first. (We presume that holding equities in your RRSP will make all gains fully taxable as income when the funds are ultimately withdrawn from the account.)
If we ignore post-tax asset allocation, and purchase $100,000 of equities in our taxable account and $100,000 of fixed income in our RRSP (a 50% equity / 50% fixed income pre-tax asset allocation), we would end up with $294,557 post-tax at the end of the 10-year period.
Option #2: Equities in the RRSP first (ignoring post-tax asset allocation)
Pre-tax asset allocation: 50% equities / 50% fixed income
If we instead held $100,000 of equities in the RRSP and $100,000 of fixed income in the taxable account, we would end up with a post-tax portfolio value of $288,325 at the end of the 10-year period, or $6,232 less than in Option #1. It would at first appear that the traditional advice is correct.
But, as we discovered in my last blog post, although the pre-tax asset allocations are the same in both examples, the post-tax asset allocations are very different. In Option #1, the investor is taking more equity risk from a post-tax perspective than the investor in Option #2 (55.56% vs. 44.44%). Here’s why: Only $80,000 of the RRSP value is really theirs; the remaining $20,000 ends up owed to the government.
To really determine whether asset location decisions matter when comparing taxable accounts to RRSPs, we need to keep the post-tax asset allocation constant. We’ll do that in our next set of examples, targeting a post-tax asset allocation of 50% equities and 50% fixed income for all three, and adjusting only the asset class locations.
Option #3 (a): Equities in the taxable account first
Post-tax asset allocation: 50% equities / 50% fixed income
In this scenario, we’ll take the traditional approach of holding equities in the taxable account first, like we did in Option #1. This gives us a pre-tax asset allocation of 45% equities and 55% fixed income, which is more conservative than the 50/50 post-tax asset mix. After 10 years, the post-tax portfolio value is $288,948.
Option #3 (b): Equities in the RRSP first
Post-tax asset allocation: 50% equities / 50% fixed income
What if we keep the post-tax asset allocation at 50/50, but first hold equities in the RRSP? At 55% vs. 45% pre-tax equities, our pre-tax asset allocation is more heavily weighted towards equities than in Option #3 (a), so this asset location decision could prove to be more challenging during a market downturn. However, the ending post-tax portfolio value after 10 years is $293,934, or $4,986 more than in Option #3 (a)).
The decision to hold equities in an RRSP first (while holding the post-tax asset allocation constant) allows the investor-owned portion of the RRSP to grow tax-free (not tax-deferred), at 7% instead of 3%, like in Option #3 (a). Holding equities with their higher expected returns in the RRSP allowed the $80,000 post-tax portion of the RRSP account to grow tax-free at 7%.
Option #3 (c): Same asset allocation across both accounts
Pre- and post-tax asset allocation: 50% equities / 50% fixed income
In this scenario, we’ll hold a pre- and post-tax asset allocation of 50/50 across both accounts. It’s no surprise that the ending post-tax portfolio value of $291,441 is somewhere between the last two outcomes.
I’ve summarized the results in the table below:
| Scenario | Asset Location Decision | Pre-Tax Asset Allocation | Post-Tax Asset Allocation | Post-Tax Portfolio Value |
|---|---|---|---|---|
| Option #1 | Equities in taxable account first | 50% equities / 50% fixed income | 55.56% equities / 44.44% fixed income | $294,557 |
| Option #2 | Equities in RRSP first | 50% equities / 50% fixed income | 44.44% equities / 55.56% fixed income | $288,325 |
| Option #3 (a) | Equities in taxable account first | 45% equities / 55% fixed income | 50% equities / 50% fixed income | $288,948 |
| Option #3 (b) | Equities in RRSP first | 55% equities / 45% fixed income | 50% equities / 50% fixed income | $293,934 |
| Option #3 (c) | Same asset allocation in each account | 50% equities / 50% fixed income | 50% equities / 50% fixed income | $291,441 |
So, once again, what would you like to do with your own portfolio? It turns out, my recommendations are similar to those from my last post.
- If you want to keep it super simple, Option #3 (c) is your easiest bet. Just hold the same asset mix across all accounts.
- For the modestly risk-tolerant investor who doesn’t mind a little extra lifting, keep following the age-old advice in Option #1 and hold the equities in your taxable account first. This presumes you can ignore the fact that you’re actually taking on more equity risk, albeit in a relatively oblivious way.
- If you believe the only right way to go is all the way, then you might prefer Option #3 (b), where you’re tightly managing your asset allocation and maxing out expected returns. Alas, many people may not grasp your attention to detail, but you might find some appreciative fans out on Reddit.
I think Justin’s article has a different focus… For those comparing the more traditional advice, like that from J Heath, of holding equities outside RRSP, I guess you have to consider that for many people without defined benefit pensions, their post-retirement income is limited to investment income and is relatively low. Therefore, they can really benefit from the Canadian dividend tax credit. You can earn ~$45,000 of Canadian eligible dividends and not pay any tax in most provinces (mostly unrealizable, that is if you have no other income), and Canadian dividends remain tax advantaged over capital gains until income reaches ~$120,000. This is probably the biggest game changer for asset location, surpassing even the (hopefully) relatively rare opportunity to harvest tax-losses.
For the very hard core, consider this site if you can manage to read all the way through:
http://www.retailinvestor.org/rrsp.html
specifically: Asset Location – Which Asset Types Are Best Inside An RRSP ?http://www.retailinvestor.org/rrsp.html#taxfree
The big knob is the (expected) tax rate difference between when you contribute to RRSP and when you withdraw.
For me, I break it down as this…
1) RRSP – Bonds=GICs, Dividends
Fill with Bonds (then with (international Developed) Dividends).
This has lowest penalty from higher withdrawal tax rate.
This shelters the high taxable payout from International Developed.
2) TFSA – Stocks, Dividends (Dividends, Stocks in my case); NO Foreign if possible.
Fill with Stocks (then with Dividends).
The largest benefit is Stocks.
The smallest TFSA benefit and lowest RRSP penalty from higher tax rate is Bonds;
Bonds are least likely for TFSA because of lowest penalty in RRSP.
3) Taxable – Dividends, Bonds (Dividends, Stocks in my case)
Fill with Dividends (Stocks), then with (tax efficient ETF) Bonds.
These have smallest benefit in TFSA or RRSP.
Bonds have lowest penalty in RRSP from higher withdrawal tax rate.
Keep Foreign assets in Taxable or RRSP rather than in TFSA, for FWTax, but no difference between RRSP and TFSA if Canadian-listed ETFs.
Take solace in noting this quote from the aformentioned site:
“If you re-balance between asset classes regularly, the Asset Location decision makes much less difference.”
My honest comment is, one should not please waste one’s limited life in such nitpicking analysis for a few dollars.
I thank you for your great efforts, but, no thanks.
Hi, I did my own calculations and it seems like you taxed the fixed income the same way you taxed the equities, just 10%. Should you not have taxed the fixed income at the full 20%?
For example, in 3b, you made 30,952 gain with fixed income in the taxable account? This should be fully taxed as income, not capital gains, and result in a post tax value of 114,762, not 117,857? Thank you
@Daniel: Please refer to paragraph 5 of the introduction to this blog (the fixed income was taxed the same as equities to keep the examples simple).
Hi Justin,
Have a more general question on tax effects of Canada domiciled vs US ETFs in taxable vs RRIF accounts, which you’ve examined before, but would like your opinion on ETF choices for ex-Canada: XWD, XAW, VXC.
We have fixed income in taxable account (Mawer Balanced) and I’d like to move the holding to RRIF since 40% FI included. I’d sell it there, then sell USD Vanguard World (VT) in RRIF to replenish holding. After a switch to MAW105 from MAW104 to pay accumulated cap gains last year, the new fund has not appreciated, so liquidating now has little effect.
To buy replacement in taxable account, I know XWD has some Canada and no emerging markets plus a higher MER than the other two. And you’ve written that the other two are strictly non-NA and have zero Canada with lower fees than XWD.
Also that XAW holds XEF which owns individual securities where tax effects may be less.
The amount involved is $150K, and not concerned over slightly reducing Canada in asset mix in portfolio, so the lower fees on XAW or VXC make them each a better choice.
Can you estimate the overall tax impact on these three, which might influence my choices and serve as a guide for all of us?
Thanx.
@Davie215: I’ll be sure to include XAW and VXC in a future update of our foreign withholding tax white paper.
Hi Justin,
I love your blog, but I have to admit, I’m very confused by this.
My main confusion is the post-tax asset allocation piece of it. You say here: “At the end of the 10-year period, the full RRSP value is taxed at 20%, while half of the capital gains in the taxable account (i.e., the taxable half) are also taxed at 20%.”
If we are talking about a post-tax scenario, then we are talking about the RRSPs having been withdrawn, or capital gains having been triggered, aren’t we? In which case, there is no asset allocation post-tax, or otherwise – the investment is gone. so I’m struggling to understand how post-tax asset allocation fits in.
I feel like I’m missing something big, here.
Also, your own calculations show that the traditional, naive advice (to which I subscribe), results in more post-tax dollars in the investors pocket at the end of the day. More money in the pocket is more or less the point of pursuing tax efficiency across the accounts, right? And when we had the flexibility of potential tax-loss harvesting in the taxable accounts, the traditional advice looks even better.
@Natasha Knox: If you consider that the 20% portion of the RRSP (and all investment earnings on it) are not yours, and the 80% portion of the RRSP and its earnings are actually a TFSA account, it makes a bit more sense (although, this topic is extremely confusing, which is why I recommend just holding the same asset allocation in each account).
The traditional (naïve) advice ends up with more post-tax dollars at the end of the day because the investor is taking on more risk. If you took on the same post-tax risk but held equities in your RRSP/TFSA first, you could potentially have even more post-tax dollars at the end of the day (but you would need to increase your pre-tax asset allocation to do so, which could cause behavioural issues).
@Justin. Thanks so much for responding!
The post that I’m responding to is your RRSP vs taxable post, not the RRSP vs TFSA post.
I understand how a portfolio can get twisted because the equities over time will probably perform better than the fixed income. So if the portfolio isn’t rebalanced, this will inevitably lead to a riskier asset allocation over time, which would also be behaviourally troublesome. We are totally on the same page with all of that.
If this were a discussion about how the traditional advice can easily lead to unbalanced portfolios over time (especially problematic in scenarios where RRSP room is perpetually maxed out), this discussion would make complete sense to me.
The part that I can’t seem to wrap my brain around, is where does the post-tax asset allocation comes in? Where is the asset? If we are talking post-tax with an RRSP the asset is gone because the RRSP has been collapsed. Same thing for the taxable investment.
I understand that only 80% of the asset in your scenario belongs to the investor, but I’m still unclear as to why the asset allocation at the point of collapse (the point where post-tax enters the discussion) is an important calculation or consideration for any investor. In my mind, the asset allocation while the portfolio is being held (pre-tax allocation) is more relevant both from a risk and behaviour perspective, than the allocation at the moment of collapse (post-tax allocation).
@Natasha Knox: As the government-owned portion of the RRSP is never yours to begin with, your post-tax asset allocation (at the very beginning) can vary significantly from your pre-tax asset allocation (at the very beginning).
If you haven’t done so already, please feel free to read the RRSP vs. TFSA post, which sets the foundation for the remaining blog posts.
Ah, okay. I’ve got it now. This is a new (to me) way of looking at it. Thanks for the perspective, and for the replies.
Interesting “concept” but for practical purposes, I still think putting equities in a taxable account is a better choice, and for one main reason: If I sell an equity at a loss, I can minimize the gain of another equity sold for a gain. That particular “tool” is not possible in a non-taxable account.
End of argument ;-)
@JackK: The ability to tax loss harvest is another reason to hold equities in the taxable account first (although since the financial crisis, there haven’t been too many opportunities for tax loss harvesting).
“I’ve also assumed all growth from equities and fixed income in the taxable accounts represent unrealized capital gains.”
In the spririt of the World Cup, this deserves an immediate red card! No VAR required. :)
In all seriousness, I come here for detailed, precise analysis. Don’t water down the product please.
@gsp: Please ask for your money back ;)
Fair enough.;)
You’ve set high standards, perhaps spoiling some of us. No offense intended.
Michael, is it really accurate to say that Jason Heath gets is wrong? I agree with you in the sense that Jason does not address tax adjusting the portfolio, which if you do that, it’s fine to hold equities in your RRSP first. But seeing virtually no one does that because it’s too complicated, especially for rebalancing, his advice of putting equities in taxable first (Option #1) is still good advice.
@Grant: I’d be more sympathetic to that argument if Heath had written that the reason people should put their GICs in their RRSPs is so that their post-tax asset allocation would then be higher in stocks than they realize. He’d then have to say that those who understand post-tax asset allocation are actually better off with stocks in their RRSPs. But he didn’t say this. It’s hard to know what’s going on in a given person’s mind, but I’ve read so often the advice to put low-yielding assets in RRSPs that it’s clear that many seemingly knowledgeable people don’t understand this issue very well. By referring to the practice of holding stocks in RRSPs as “strange,” I had to conclude that Heath may not understand this issue well either.
Hello,
Just a “meta-comment” on the weblog in general and not on the particular topic of the article: None of your posts have any date in them. Not in the body of the post, nor in the URL link.
If someone comes across any post via a search, they have no idea how stale or fresh the information is, especially if there have been tax code changes over the years.
Is there any way to add that information (at least for future posts)?
Never mind. I see the date at the bottom of the post, in a very small typeface.
Justin, I think I prefer the option of taking a bit more risk in an oblivious way – especially seeing I’m using the government’s money to do so.
@Grant: I think your preferred method is completely acceptable (as are the other options).
Fun! Now we just need a calculator that incorporates the rrsp tax issues. I guess these concerns apply more to those with maxed out rrsps as another level of consideration would be needed to incorporate the fact that you would have more $ working for you faster if you were choosing between the two and the likelihood of lower tax brackets upon retirement.
With dividends taken into account my calculations seemed to lean towards rrsp if I was choosing a us $ international etf and holding for 25 years. I included a tax rate change higher to lower at 71. There seems to be a large window for the benefit of planned income smoothing.
So,.. 90k equities in taxable account is still more, 168300 post tax than 100k equity in rrsp 157300 post tax. If one allowed the higher growth holdings to dictate location equity investments should be held in taxable accounts if taxes remain constant. Is this statement correct?
Great post!
@Phil: I’m not sure I understand your question. If you calculate your asset allocation from a post-tax perspective, holding equities in your RRSP account (not your taxable account) is likely to result in a higher post-tax portfolio value. $90K of equities in a taxable account is not the same as $100K of equities in an RRSP account (assuming a 20% tax rate, there are really only $80K of equities in the RRSP account – so it is not a fair comparison).
Oops my mistake, should have compared the result of 80k in taxable which would be 157300 – 5730 (tax)= 15570. So I see, slightly less than post tax rrsp value. Thanks for your help.
Never mind, I guess i didn’t read your blog very closely, you’ve already taken it into account. Please disregard my previous post, thanks!
@Jonathan Lee: Will do, thanks! ;)
Thanks so much Justin for doing the breakdown on this pre-tax / post-tax conundrum.
When dealing with a taxable account, wouldn’t you also need to take into consideration that you would need to pay taxes on any dividends, capital gains, etc., earned in that account?
Nice post. I was just starting to write the same thing after reading Jason Heath’s MoneySense piece (https://www.moneysense.ca/save/retirement/rrif-annuity-rrsp/) where he gets it wrong.
@Michael James: Thanks! I’m still going to post on TFSAs vs. Taxable Accounts (which is relatively straight-forward), and then I may follow-up with a more practical blog post pulling everything together using ETFs in the examples.
@ Michael James – I’m curious as to how Jason Heath “gets it wrong” ?
@fbgcai: Here’s the quote:
“From an asset allocation perspective, you may want to consider holding your low-yielding fixed income in your RRSP (where the income is tax-sheltered) and instead hold equity investments (stocks, stock ETFs, stock mutual funds) outside your RRSP (whether a non-registered account or Tax-Free Savings Account). Interest is taxed at a higher tax rate than capital gains or Canadian dividends. But strangely, I often encounter people with equities in their RRSPs and savings accounts and GICs in their taxable accounts.”
Justin’s article explains why this is not tax-efficient.
Also low yielding items in rrsp will accumulate less growth over long periods leading to less to tax at withdrawal… leaving high growth in a more flexible and tax advanged position.