Key Portfolio Issues - Let's work through an example to see how it could look in practice, considering these factors:
- Canadian taxes - See our posts on the general principles to apply for income level and province, choice of RRSP vs TFSA vs Taxable account and RRSP vs TFSA critical differences,
- US and International withholding taxes - How this affects investments is explained in Pros and Cons of Cross-Border Shopping for ETFs; there is a worked-out example together with a link to a free downloadable spreadsheet to test other ETFs in the Cross-Border ETF Free Tool post
- RRSP, TFSA account limits - $5,000 per year for TFSA, which three years after startup, amounts to a total possible of only $15,000 and 18% of earned income for the RRSP (see TaxTips.ca here for details). Come January 1, 2012, the TFSA contribution limit will rise another $5,000.
- Rebalancing in future on a regular basis to keep the portfolio in line with the intended allocation
1) RSSP and TFSA are the major accounts for the portfolio - The tax-free growth in both the TFSA and RRSP produces the best long run returns and that's where everything should go if possible. However, we assume for illustration purposes that the investor has run out of RRSP room and must also maintain a taxable account, which allows us to show what should go in there. We also assume that the person wants to use both a RRSP and a TFSA but of course the TFSA has a $15k contribution limit. A person in the highest tax bracket might want to concentrate everything in the RRSP.
2) Cash is split amongst all three account types to facilitate rebalancing. Possibly the cash may be handy for emergency needs and it can be put back into the account when it is in a TFSA (in the following calendar year) or a taxable account (anytime). Note that the Manulife Financial Investment Savings Account (MIP510), may face higher minimum purchase amounts from certain brokers though Manulife itself does not impose a minimum.
3) Highest tax rate interest bearing bond ETFs go in the RRSP or the TFSA where there is tax protection.
4) TFSA gets some bonds and some equity to facilitate rebalancing, since those are the assets most likely to move in different directions. Equities worldwide tend more to move in sync. It is far easier to do rebalancing trades within an account. Indeed, it is not permitted to transfer money into a TFSA to rebalance if the TFSA's contribution limit has been maxed out. Taking money out of the RRSP to rebalance to a Taxable account loses the tax advantage so that doesn't make sense. The Claymore 1-5 Year Government Bond ETF (CLF) is split between RRSP and TFSA since it has a bigger allocation and will be cheaper to rebalance considering trading costs. Similarly it is the larger iShares S&P/TSX Capped Composite Index Fund (XIC) that is split between the RRSP and the TFSA.
5) Taxable account gets ETFs with US and international holdings due to foreign withholding taxes that cannot be recovered.
The same principles would apply to other ETFs that can be used to construct the same or other portfolios. The percentage allocations may vary towards more or less fixed income or equities but the asset classes and the tax characteristics will be the same.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
5 comments:
I am in total agreement that your portfolio needs to be managed as a whole and that this is a huge issue with many portfolios that operate in silos. However, why would you not have all equities in your TFSA and exclude the bonds if as a whole you have your proper diversification? Should you not be looking for the maximum tax-free appreciation; you do not need balancing within specific accounts, just balancing overall?
Hi BBC, good questions. 1) TFSA cannot hold all the $20k XIC equity because the total contribution limit is only $15k. 2) even if it could, what happens after a big market swing? e.g. graph CLF vs XIC for 2011 - from the beginning of 2011, by April XIC vs CLF had diverged about 15%. That could trigger a rebalance but unless there was unused RRSP contribution room, you could not move funds from the TFSA/XIC to RRSP/CLF. Subsequently, the market has swung in the opposite direction and the rebalance today would be from CLF to XIC but if you had maximized the TFSA funds could not flow from RRSP to TFSA. Transactions within each account could do the rebalancing each time but inevitably you would end up with holdings of both ETFs in both accounts. The idea is not to balance within each account, just overall.
Shouldn't the "foreign" etf's be in an RRSP account as their returns are fully taxed as if interest income, and the Canadian etf's in taxable accounts due to preferable treatment of dividends and capital gains?
Hi Anon,
Good question. The general principle that all investments should go in taxable accounts is valid. For purposes of the blog post to illustrate, we assumed the investor had run out of total RRSP & TFSA space and so had to use a taxable account. In that case those US and International ETFs go best in the taxable account where the foreign withholding taxes do not get lost. It's especially bad for the specific ETFs CWO because it holds a US ETF inside, Vanguard's VWO, and for XSP, which holds the US-based IVV. If the portfolio held VWO and IVV instead, those two ETFs could reside equally in the RRSP (but not the TFSA). That conclusion shows up through using the Cross- Border ETF comparison tool linked to in the post - http://howtoinvestonline.blogspot.com/2011/05/cross-border-etfs-heres-free-tool-to.html
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