Where to Put your Investments for Maximum Tax Efficiency

I’ve been getting a number of emails from readers about dividend investing and which type of investment account to use for maximum tax efficiency.  This article should help clear up some of those questions. This post has been modified and expanded but was originally written in 2009.  

Efficiency is the name of the game not only with investing but with many aspects of life.  For the next few moments, let’s focus on tax efficiency within your investment account.

Investors talk a lot about diversification and asset allocation, but what about portfolio allocation? That is, once the diversified investments are chosen, where do I put them for maximum tax efficiency?

Basically, portfolio allocation is the most tax efficient way to hold your securities based on the taxation of both the security and the account in the view that all your assets are a giant portfolio instead of multiple sub accounts.  At least that’s how I define it. :)

Backgrounder on Investment Taxation

Let’s take a look at various investment instruments and their tax consequences:

• Canadian Dividends – Dividend tax credit makes Canadian dividend income relatively tax efficient in a non-registered (ie. taxable) account.  The higher your income, the less tax efficient Canadian dividends become.
• Foreign Dividends – In non-registered accounts, foreign dividends are taxed 100% at your marginal tax rate (ie. if you are in the 40% tax bracket, you will pay $40 in tax for every $100 foreign dividend).  In TFSA’s foreign dividends will face a non-recoverable withholding tax.
• Bonds/GICs/Money Market – In a taxable account, interest is taxed at 100%.
• Income Trusts/REITS – Income Trust distribution varies between capital gain, return of capital, interest, and dividends.  Due to the mish-mash of distribution content and complications during tax filing, I keep my income trusts and REITs within a tax-sheltered account like an RRSP or TFSA.

Big Picture Portfolio Tax Efficiency

Before I get into where each investment belongs, there is a broader discussion of taxation of accounts after retirement.  A number of people out there think that RRSPs are a scam or a rip-off.  That is simply not true.  There are groups of investors that would benefit from RRSPs (see below) and also some that will not benefit at all.

An RRSP is essentially a reverse TFSA  (ie. RRSP you are contributing pre-tax, TFSA you are contributing post-tax).  However, there is an exception.  The big advantage of TFSA withdrawals are that they do not count towards government program thresholds (like guaranteed income supplement and old age security – avoiding clawbacks in these programs explained in links below). 

Some general guidelines:

• If you are low income with savings, take advantage of TFSAs and avoid RRSPs (to reduce GIS clawback).
• If you are high income, take advantage of both RRSPs and TFSAs.
• If you expect a large government or other defined benefit pensions in retirement, maximize TFSAs before RRSPs (to reduce OAS clawback).

Maximizing Tax Efficiency in your Portfolio

Now that we have the big retirement picture out of the way.  Let’s get down to the crux of the topic – where should you put each investment type?

As a general conclusion, you’ll want to maximize tax-sheltered accounts before putting investments within a taxable account.

Here is an example of an index investor with a simple portfolio that may consist of globally diversified index funds/ETFs, bonds, and cash.

RRSP:

• Fixed Income/Bonds/GIC’s
• Foreign Equities
• Income Trusts
• REITs
• Canadian Equities

TFSA

• Fixed Income/Bonds/GIC’s
• Income Trusts
• REITs
• Canadian Equities

Non-Registered:

• Canadian Equities (only if tax-sheltered accounts maxed out)

To get a little more specific, say the investor held: XIC (Canadian index), XUU (US index), XEF (International Index), VRE (REIT index), and VAB (bond index).

• XIC – Canadian Index (RRSP, TFSA or Non-registered if all others maxed out);
• XUU – US Index (RRSP);
• XEF – International Index (RRSP);
• VRE – REIT Index (TFSA); and,
• VAB – Bond Index (TFSA).

My Portfolio

My current investment accounts have quite a few holdings but are generally tax efficient.  At a high level (this does not count my corporate portfolio):

• Foreign holdings and fixed income are within RRSP accounts (could also put bonds in TFSA).
• REITs and some high yield Canadian dividend stocks are held within TFSAs.
• Since our registered accounts are maxed out, we hold most of our Canadian equity exposure within taxable accounts.

You can see more of my portfolio contents here.

Final Thoughts

One word – efficiency!  It generally makes sense to maximize your registered investment accounts before moving into taxable accounts.  However, if you save more than your tax-sheltered accounts will allow, you may want to shuffle around your investment assets to minimize taxation where possible.