Much has been written about optimizing your portfolio(s) for tax efficiency by placing certain investments or asset classes in certain accounts. This tax planning strategy is called asset location.
In this article I’m going to explain what asset location is all about, what optimal asset location can achieve, and why you should forget about it and just hold the same asset mix across all your accounts.
What Is Asset Location?
Most investors know about asset allocation – the mix of stocks, bonds, and other asset classes (gold, real estate, etc.) used to build a portfolio. For example, a classic 60/40 balanced portfolio would hold 60% stocks and 40% bonds.
But what happens when you hold investments inside an RRSP, a TFSA, and maybe a LIRA from a previous employer? What happens when you add a taxable or non-registered investment account to the mix?
This is where asset location comes into play. Asset location is about determining which assets to hold in each account. Why? Two reasons:
- The returns from capital gains, interest, and dividends are all taxed in different ways.
- Each of your accounts (RRSP, TFSA, non-registered) have different tax rules.
I’ll summarize what Preet Banerjee wrote in this 2013 MoneySense piece (“Everything in its place“):
- Interest income earned from savings accounts, GICs and bonds is taxed at your highest marginal rate.
- Capital gains are taxed more favourably and only when the gains have been realized (i.e. when you sell). You’ll pay tax on 50% of the gain – again, at your highest marginal rate.
- Canadian dividends get special treatment with the dividend tax credit, with a greater advantage to those in a lower tax bracket.
- Foreign dividends are taxed at your highest marginal rate, just like interest. Many countries also impose a withholding tax on dividends paid to foreign investors – most notably the 15% foreign withholding tax on U.S. dividends.
Many investment advisors look for ways to optimize asset location to better take advantage (or lessen the disadvantage) of these different tax treatments. They accomplish this by placing certain assets in either a tax-deferred, tax-free, or taxable account:
- An RRSP is a tax-deferred account, meaning all investment growth (from capital gains, interest, and dividends) is sheltered from tax until withdrawal. RRSPs are also exempt from foreign withholding taxes on U.S. dividends.
- A TFSA is a tax-free account where all investment growth is sheltered from tax and future withdrawals are also tax free. Foreign withholding taxes apply and are not recoverable.
- A taxable account is a non-registered account where any interest and dividend income is taxable in the year it’s earned. Capital gains are taxable if and when they are realized. Foreign withholding taxes do apply, but you can be offset by claiming a credit on your tax return.
An optimal asset location strategy puts interest-bearing investments (fully taxable in the year earned) into a tax-deferred or tax-free account. It puts Canadian stocks and preferred shares in a non-registered or taxable account. Foreign dividend paying stocks (particularly U.S. stocks) go into a tax-deferred account. Same with REITs, thanks to their not-so-tax-efficient income.
- Bonds, GICs, high-interest savings – RRSP or TFSA
- Canadian stocks and preferred shares – Non-registered (taxable) account
- U.S. and foreign dividend paying stocks – RRSP
- REITs – RRSP or TFSA
What Does Optimal Asset Location Achieve?
In a 2013 paper from Morningstar, the authors determined that an optimal asset location strategy might lead to a 0.23% per year increase in after-tax returns (versus holding the same asset mix in each account).
In a 2014 paper, PWL Capital’s Justin Bender and Dan Bortolotti looked at an ETF portfolio held from 2003 – 2012 and found that optimal asset location would have added 0.30% per year to the after-tax returns.
Finally, in a 2017 paper, PWL Capital’s Ben Felix found that optimal asset location could ideally add 0.23% per year to after tax returns.
In a world where ETF investors change portfolios just to save 0.25% per year in fees, striving for an optimal asset location strategy to increase after-tax returns by as much can sound compelling.
Unfortunately, once again what looks optimal on a spreadsheet can prove to be impossible to manage in real life. As Ben Felix explains, the analysis is based on expected future returns, which are unknowable in advance. Other issues include:
- Regulatory risks – What if tax rates or other tax laws change?
- Room for error – Given all the future unknowns, even financial professionals and academics often heatedly debate just what qualifies as “optimal” asset location.
- Added complexities – Obviously, it takes a lot more time and energy to engage in asset location than to simply duplicate the same asset allocation in each account. Is the potential value-added worth it?
- Debilitating distractions – Asset location may cause more harm than good if it distracts you from other investment best practices, such as remaining fully invested and engaging in periodic rebalancing.
The bottom line: investors should be wary of going too far down the asset location rabbit hole. It’s allowing the tax tail to wag the investment dog.
Forget About Asset Location
Asset location is an idea that sounds good in theory, but can be a nightmare to manage in practice.
First of all, asset location shouldn’t be a concern at all for investors who only contribute to an RRSP and/or TFSA – especially if the portfolio is small. The asset location question should only come into play once your tax-sheltered accounts are maxed out and you start to hold investments in a taxable account.
Also, investors have been beaten over the head with the idea of optimal asset location that many are either:
- paralyzed to make an investment decision for fear of making a mistake, or;
- overcomplicating their portfolios and making them impossible to manage.
So, what’s the solution?
Forget about asset location. That’s right. Forget it.
Instead, simply hold the exact same asset mix across all accounts. That means if your ideal asset allocation is 60% stocks and 40% bonds, then the simplest and most effective solution is to hold the exact same 60/40 portfolio in your RRSP, TFSA, and non-registered accounts.
My own target asset mix, for now, is 100% equities and so I practice what I preach and hold Vanguard’s All Equity ETF Portfolio (VEQT) in each of my RRSP, TFSA, and newly set-up LIRA.
In fact, asset allocation ETFs like Vanguard’s VBAL (60/40) and VGRO (80/20) are ideal for investors who want to hold the same asset mix across all accounts and don’t want the hassle of monitoring and rebalancing their portfolio.
Can an optimal asset location strategy add value? In hindsight, the evidence showed that optimal asset location might have increased annual after-tax returns by between 0.23% to 0.30%. But “optimal” also meant an investor in the highest marginal tax rate who executed the strategy perfectly over many years.
In reality, there are too many future unknowns and too much room for investor error to conclude that optimal asset location is a strategy worth pursuing.
Instead, my advice is to forget everything you’ve read about asset location and instead hold the same asset mix (i.e. the same portfolio) across all accounts to reduce complexity and behavioural bias.