Thursday, 24 November 2011

ETF Asset Allocation across RRSP, TFSA and Taxable Accounts

Many investors, including this blogger, whether by intent or happenstance, have their investments spread across multiple account types, such as RRSP (or a LIRA), TFSA and Taxable/Non-registered. As we advocate in this blog, the wise investor diversifies across different types of investments to maintain a portfolio asset allocation with the percentage breakdown specified to meet investment objectives - see example in our post on investment policy. A fundamental principle is that though the portfolio may span many accounts it should be managed as a whole, not as independent pieces. The next question then is - What is the best way to divide up the investments across the two dimensions of account type and asset type?

Key Portfolio Issues - Let's work through an example to see how it could look in practice, considering these factors:
Our example portfolio contains $100,000, a nice round number that makes it easy to match up percentage breakdown and dollar amounts. Our portfolio uses the ETFs and breakdown in the Balanced Portfolio suggested in the just-released update edition of Gail Bebee's book No Hype: The Straight Goods on Investing Your Money.

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.


The Blunt Bean Couner said...

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?

CanadianInvestor said...

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.

Ruby Claire said...
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Anonymous said...

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?

CanadianInvestor said...

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 -