If you’ve stuck with me through my last three asset location blogs, congratulations. Don’t ever let some sissy Iron Man Triathlon champion tell you they’ve got more endurance than you do.
The good news is, we’re nearing the end. This post will hopefully be my last word on the matter, as we explore how to build your tax-efficient ETF portfolio across multiple accounts using optimal asset location. But fair warning: There’s one more hurdle separating you from your ideal asset location. Here’s the equipment you’ll require to reach the finish line:
- A DeLorean time machine with a functional flux capacitor (just like the kind Marty McFly used in “Back to the Future”)
- 1.21 gigawatts of electricity (generated by plutonium, a bolt of lightning, or a yet-to-be-fabricated Mr. Fusion charger)
In other words, the only thing standing between you and sure-fire asset location is the ability to time travel. Since anything else is largely guesswork about what the future holds, it’s the only way to readily define what “optimal” will actually turn out to be, according to these steps:
- Once you’ve reached the future, you’ll want to review your (future) past tax returns to calculate your effective tax rate on all registered withdrawals.
- Do the same for any taxable capital gains you’ve realized over the (upcoming) years.
- Next, once you’ve returned to good old 2018, you may find that your present life also needs a few adjustments to improve your future situation, now that you know what it will be.
- Finally, remember that any financial changes in the present could alter your future tax rates, which means you may have to travel back to the future several times until you get it right.
Great Scott. Without that time machine, you may need to accept your inability to predict future effective tax rates, expected returns or asset class investment income distributions. What then?
Let’s face it. Most DIY investors may be better off simply holding the same asset mix in each account type. Then again, with the stamina you’ve exhibited so far, you may not be “most DIY investors.” You may still yearn to know what it would look like to go the distance in pursuit of optimal asset location.
Here’s what’s involved. Let’s assume that you’ve decided to implement the Canadian Portfolio Manager 40% bonds / 60% stocks model ETF portfolio. For that, I’ve included the balanced model portfolios below for each account type as of June 30, 2018. We’ll assume you’ve got enough clairvoyance to determine you’re expecting to incur a 30% effective tax rate moving forward.
Your initial portfolio is reasonably straightforward: $300,000 of cash split evenly across a TFSA, RRSP and taxable account. If your future effective tax rate on RRSP withdrawals is 30%, the post-tax value of the RRSP is actually worth $70,000 [$100,000 × (1 – 30%)].
Next, we’ll plan to invest the cash in the most “optimal” way possible, by holding equities in the TFSA or RRSP account first, while ensuring that we are managing the asset allocation from a post-tax perspective (i.e. we’ll ignore the $30,000 portion of the RRSP account that is owed to the government).
Step 1: Buy $54,000 of VCN in the TFSA
Let’s start by purchasing the Vanguard FTSE Canada All Cap Index ETF (VCN) in the TFSA account.
In my blog post, Asset Location in a Post-Tax World: TFSAs vs RRSPs, I showed that, as long as you manage your portfolio’s asset allocation from a post-tax perspective, it’s largely irrelevant which asset class you hold in your TFSA versus your RRSP. However, foreign withholding taxes can complicate the decision, since withholding taxes on foreign dividends will apply in a TFSA. As Canadian investors don’t incur withholding tax on dividends received from Canadian equity ETFs, holding VCN in the TFSA first will be slightly more tax-efficient than holding foreign equity ETFs.
To determine how much VCN to buy, we’ll multiply our post-tax portfolio value of $270,000 by VCN’s target asset allocation in our model portfolios of 20%, which equals $54,000.
Step 2: Buy $18,129 CAD ($13,767 USD) of IEMG in the US dollar RRSP
When holding a Canadian-listed emerging markets equity ETF in an RRSP or TFSA, two layers of unrecoverable withholding taxes are generally levied on foreign dividends. You can avoid one of these taxable layers in your RRSP by instead holding a US-listed emerging markets equity ETF, like the iShares Core MSCI Emerging Markets ETF (IEMG). (Unfortunately, doing the same thing in your TFSA does nothing to reduce this tax drag.)
It’s a bit trickier to calculate how much IEMG to buy. We first need to calculate how much to purchase in post-tax Canadian dollars by multiplying our post-tax portfolio value of $270,000 by IEMG’s 4.7% target asset allocation in our model portfolios. This equals $12,690 CAD post-tax. We then need to gross up this figure by dividing it by 0.70 (or 1 minus our 30% tax rate). This equals $18,129 CAD pre-tax.
Also, since IEMG trades in US dollars, you’ll need to convert the $18,129 CAD figure to USD before calculating the number of shares to purchase. Using the June 29, 2018 Bank of Canada exchange rate of 0.7594 (1 CAD = 0.7594 USD), you could purchase $13,767 USD of IEMG ($18,129 × 0.7594).
If you don’t have enough US dollars available in your RRSP account, consider using the Norbert’s gambit strategy to convert your Canadian dollars to US dollars before purchasing IEMG.
Step 3: Buy $81,871 CAD ($62,173 USD) of ITOT in the US dollar RRSP
Withholding taxes of 15% are also levied on dividends paid from Canadian-listed US equity ETFs. But you can avoid these taxes in an RRSP by holding a US-listed US equity ETF, like the iShares Core S&P Total U.S. Stock Market ETF (ITOT). (These taxes are still applicable in a TFSA.)
Multiplying the post-tax portfolio value of $270,000 by ITOT’s target asset allocation of 22% gives us $59,400 CAD post-tax. We again need to gross up this figure by dividing it by 0.70 (1 minus our 30% tax rate), which equals $84,857 CAD.
You may already have noticed, after our purchase of IEMG in Step 2, we only had $81,871 CAD left in our RRSP ($100,000 CAD minus $18,129 CAD). We can purchase this amount for now. In Step 4 below, we’ll purchase the rest in the TFSA. Purchasing $81,871 CAD pre-tax is equivalent to purchasing $57,310 CAD post-tax [$81,871 × (1 – 30%)].
As ITOT also trades in US dollars, we’ll need to convert our Canadian dollars to US dollars before purchasing the fund. As we currently have $81,871 CAD, this is equivalent to $62,173 USD ($81,871 × 0.7594).
Step 4: Buy $2,090 of XUU in the TFSA
In Step 3, we calculated that we required $59,400 CAD post-tax US equity ETFs. We were only able to purchase $57,310 CAD post-tax of ITOT, so we still need another $2,090 CAD in another US equity ETF. Since holding US-listed US equity ETFs in a TFSA does not avoid the 15% foreign withholding taxes, we’ll instead purchase $2,090 CAD of the Canadian-listed iShares Core S&P U.S. Total Market Index ETF (XUU) in the TFSA. This also avoids the complication and cost of currency conversions.
Step 5: Buy $35,910 of XEF in the TFSA
Holding Canadian-listed international equity ETFs (which hold the underlying stocks directly) eliminates one of the layers of foreign withholding taxes. So it’s more tax-efficient to hold something like the iShares Core MSCI EAFE IMI Index ETF (XEF) in a TFSA than holding a US-listed international equity ETF. To determine the amount of XEF to buy, we’ll multiply our post-tax portfolio value of $270,000 by the 13.3% target asset allocation of XEF in the model portfolios, which equals $35,910 CAD.
Step 6: Buy $8,000 of ZAG in the TFSA
Now that all the equity ETFs have been purchased, we can tend to our fixed income ETFs. We still have $8,000 CAD of cash available in the TFSA account, so we can use it to buy the BMO Aggregate Bond Index ETF (ZAG).
Step 7: Buy $100,000 of ZDB in the taxable account
Finally, we have $100,000 CAD cash sitting in the taxable account, and we still need to purchase $100,000 of fixed income ETFs. You can probably reduce your annual tax bill a bit by choosing a more tax-efficient ETF, like the BMO Discount Bond Index ETF (ZDB).
Fancy steps, but where will they lead?
Well, that was a blast wasn’t it? In the end, we needed to increase our pre-tax stock asset allocation to 64% (compared to 60% post-tax). If the RRSP account was relatively larger than the other accounts (or the tax rate was higher), the pre-tax allocation to stocks could have been much higher (although this may have made the additional pre-tax risk hard to stomach during market swings).
Again, there’s a big catch to all this fancy footwork: Without the foresight a time-machine would afford us, we cannot accurately predict future effective tax rates. It’s equally as challenging to forecast expected returns or income distributions for the asset classes in which we’re invested. On top of that, acting on our assumptions is a complicated process, which we’ll need to revisit periodically to keep the portfolio on track.
So, again, I encourage most DIY investors to simply hold the same asset mix in each account type. If you must go the extra mile, you can still do so by choosing the most tax-efficient ETFs for each account type (as presented in my TFSA, RRSP and taxable model ETF portfolios). That’s likely to earn you a few more post-tax dollars along the way, without exhausting the precious energy you’ll need to go the distance with your efficient portfolio management.
Asset Class Pre-Tax Asset Allocation Post-Tax Asset Allocation
Canadian Bonds 36.0% 40.0%
Canadian Stocks 18.0% 20.0%
US Stocks 28.0% 22.0%
International Stocks 12.0% 13.3%
Emerging Markets Stocks 6.0% 4.7%