In my last blog post, I showed Couch Potato investors how they could reduce the foreign withholding tax drag in their RRSP accounts by holding US-listed ETFs. I’ll admit that the proposed ETF changes required investors to roll up their sleeves a bit, but the cost savings could not be ignored. But what if an investor wanted to implement the Couch Potato portfolio in a taxable account – is there any room for improvement?
It turns out there is. The Vanguard Canadian Aggregate Bond Index ETF (VAB) is not the best choice for taxable accounts. The fund holds bonds with a higher weighted average coupon than their weighted average yield-to-maturity (these bonds are also known as “premium bonds”). Ideally, taxable investors want to purchase bonds that have a yield-to-maturity equal to their coupon (referred to as “par bonds”). Or better yet, they would prefer bonds with a coupon that is lower than their yield-to-maturity (referred to as “discount bonds”).
Luckily, the BMO Discount Bond Index ETF (ZDB) was created as a solution to this premium bond issue. The fund purchases bonds that have much lower coupons than VAB, but about the same yield-to-maturity. Translation – same before-tax return, higher after-tax return. Let’s take a look at how substituting ZDB for VAB in a balanced Couch Potato portfolio would have fared last year.
The chart below compares the taxes paid on two portfolios. The first portfolio holds VAB while the second portfolio substitutes ZDB in its place. I’ve assumed that all ETFs were purchased at the end of 2014, and held throughout the 2015 tax year. The ‘Taxes (2015)’ column estimates the amount of taxes that would have been payable by an Ontario resident in the top marginal tax bracket during the year for each of the ETFs. Holding VAB instead of ZDB resulted in an additional tax bill of $1,750 during the year (or an additional cost of about 0.175% on the overall portfolio). The taxes would have increased further if bonds had made up a higher proportion of the investor’s overall portfolio.
2015 Estimated Taxes
|Portfolio 1||Shares||Market Value ($)||Taxes (2015)|
|Vanguard Canadian Aggregate Bond Index ETF (VAB)||15,664||$400,000||$5,613|
|Vanguard FTSE Canada All Cap Index ETF (VCN)||6,816||$200,000||$1,659|
|Vanguard FTSE Global All Cap ex Canada Index ETF (VXC)||15,111||$400,000||$4,917|
|Portfolio 2||Shares||Market Value ($)||Taxes (2015)|
|BMO Discount Bond Index ETF (ZDB)||25,575||$400,000||$3,863|
|Vanguard FTSE Canada All Cap Index ETF (VCN)||6,816||$200,000||$1,659|
|Vanguard FTSE Global All Cap ex Canada Index ETF (VXC)||15,111||$400,000||$4,917|
Source: CDS Innovations Inc., BMO ETFs, Vanguard Canada
BMO also recently announced that they have lowered the management fee on ZDB to 0.09% (from 0.20%), which is one more reason to favour ZDB over VAB in taxable accounts (VAB currently has a management fee of 0.12%).
It’s my CCPC questions again.
Rather than laddering GIC’s in my CCPC would it be very silly to just hold VAB now that the MER has decreased to 0.08% to allow for liquidity if I need to buy equities later on?
It would be about 500K in a bond ETF.
@Miwo: ZDB or HBB are more tax-efficient bond ETFs than VAB, so you may want to consider one of these ETFs instead.
@Justin: Thanks so much for your valuable articles!
I need to hold fixed income in taxable accounts (maxed-out registered accounts), and learned from your posts that a tax efficient way is to use a combination of GICs and tax-efficient bond ETF (e.g. BXF or ZBD). In addition to liquidity and return, what other factors I should take into consideration when deciding on how much of it to hold in GICs and how much in a bond ETF?
@JamesB: I tend to combine a 1-5 year GIC ladder with a tax-efficient broad-market bond ETF. In terms of the split, a good starting point would be to first determine how much you would need in a liquid bond ETF to rebalance the portfolio in the event of a stock market downturn of 50%.
For example, if you had a 60% stock / 40% bond asset mix, and your portfolio was worth $100,000, you would have $60,000 in stocks and $40,000 in bonds. If stock markets declined by 50%, you would now have $30,000 in stocks and $40,000 in bonds (for a total portfolio value of $70,000).
In order to rebalance the portfolio back to its 60% stock / 40% bond asset mix, you would need to sell $12,000 of liquid bonds and buy the same amount of stocks ($70,000 x 60% = $42,000 – $30,000 = $12,000). So for the initial portfolio, you could allocate $12,000 (or 12%) to bond ETFs, $28,000 (or 28%) to 1-5 year GICs and $60,000 (or 60%) to stocks.
@Justin: For DIY investors that only use Canadian listed ETFs, what is more tax-efficient in a Non-Registered account after Canadian equities, ZDB or XUU/ VUN? I’m having a hard time determining which security would be best to move out of registered accounts after Canadian equties. As always I very much appreciate the time you spend on the blog and the great information you make available to investors.
@Shawn: It depends on the investor’s specific situation. In a similar situation, I would generally hold the US-listed foreign equity ETFs and bonds in the RRSP accounts and Canadian equities in the taxable accounts. If I did not require additional Canadian equities in the taxable account (but I had cash to invest), I would tend to purchase a tax-efficient bond ETF (like ZDB) next, as it would not disrupt what I am doing in the RRSP account (i.e. I would not be forced to start converting USD back to CAD).
It also gives you better liquidity if you need to access taxable funds (you will not likely have to realize significant capital gains on the bond ETF). This is a benefit that is often overlooked by investors.
@Justin, thank you for your response. Would there be any concerns in having VUN or XUU in a regular taxable account? Would I still have to fill out the T1135 CRA form?
@Howie: There would be no need to complete a T1135 form if you hold VUN or XUU in a taxable account. You’ll need to adjust the cost base each year for return of capital and reinvested distributions though: https://www.pwlcapital.com/pwl/media/pwl-media/PDF-files/White-Papers/PWL_Bender_As-Easy-as-ACB_2015-January.pdf?ext=.pdf
Hi Justin, I noticed that you don’t have any REITs in your portfolio? Wouldn’t it make sense to buy VRE and put it in a TFSA account to make it tax efficient? Also, what are your thoughts of having VTI in a regular taxable account?
@Howie: I used to include a small portion to REITs in my model portfolios (about 10% of the overall equity allocation), but this just caused more complexity than I felt it was worth (REITS are usually added to a portfolio with the expectation that they slightly decrease the portfolio’s volatility). Over the many years working with DIY investors, I settled on a more straight-forward asset mix.
VTI in a taxable account does not have much of a benefit over VUN or XUU (other than a slightly lower MER). There are also additional costs for currency conversion, and possible US estate tax issues (not to mention annoying CRA T1135 tax reporting in some cases).
He Justin what do you think of my portfolio all in my TFSA
I am a 37 year old male
@Nick: I’ve posted my preferred portfolios on my model ETF page: https://www.canadianportfoliomanagerblog.com/model-etf-portfolios/
XAW may be a slightly more tax-efficient alternative to VXC in a TFSA as well (it is also a decent one-fund substitute to VUN/XEF/XEC in my model ETF portfolios).
Awesome article and example, and thanks again for continuously publishing this stuff. Through your site and Dan’s, I have taught myself to create, clean up, and manage my own portfolio over the last 5 years and couldn’t be happier.
My current portfolio is allocated much like your example (though with different account sizes and ratios). One question I have grappled with – and I am probably using the wrong terminology here – but the balance between “annual” taxes (ie taxes from distributions & any cap gains, due every year) vs. long term tax liability.
If we consider the former, then your allocation above makes the most sense (keeping foreign equity in the RRSP to minimize FWT). But it ignores the latter. In other words, you have allocated the Fixed Income, which ought to be the asset with the lower rate of return, to the Taxable account, and equities (which ought to have the higher return) to RRSP. I am young(ish) and in the accumulation phase and would think that over a long period, say 30yrs, if we assumed perhaps a 2-3% return difference between equities and FI, this would have the effect of resulting in a much larger RRSP account vs. Taxable than if we had done the opposite (FI in RRSP and equity in Taxable). This would obviously be worse as growth in my RRSP is taxed as income while Taxable growth is taxed at half that as cap gains.
Have you done any calculations to this effect or have any thoughts?
@Willy: Thank you for your comments. This type of analysis would be difficult (impossible) to perform with any accuracy, as there are too many unknown variables. For example, if you held international equities in a taxable account (instead of tax-efficient fixed income), you are now paying tax on a ~3% dividend yield each year (which over time would leave you with less taxable investments from an after-tax point of view). Rebalancing the portfolio over time in a taxable account will also lead to higher taxes payable. Unexpected calls on capital in a taxable account could also lead to higher taxes payable, if equities need to be sold at a gain.
This is why I would never argue with an investor that decided to hold all asset classes in the same weights across all accounts. There are many benefits from this strategy that are often overlooked. For investors, I would recommend focusing more on what we can control to a reasonable degree (reducing taxes on current income, foreign withholding tax mitigation, currency conversion cost reduction, fee reduction, better tax-efficient product selection, behaviour, etc.), and less on things like optimal asset location, which is unknown in advance, no matter how much analysis you do.
Hi Justin, thanks for this latest series of posts, always makes for an interesting and thought provoking read.
Do you not discount tax deferred accounts when applying your desired AA? I try to do so according to the projected tax rate on exit. For instance if John Smith thinks his RRSP withdrawals will incur an average 25% tax, I would consider his portfolio to only be 900k and allocate it as follows depending on his comfort level with swap based products.
360k HBB/ZDB unregistered
180k HXT/VCN unregistered
10k HXS/VUN unregistered
227k VTI RRSP
50k XEF TFSA
125k IEFA RRSP
48k IEMG RRSP
Keep the posts coming. :)
@gsp: You’re very welcome!
When I combine the financial planning process with the portfolio management process, it factors in taxes payable, so I tend to allocate based on how much risk the investor requires to meet their goals – I feel that it’s a slightly more accurate process. The main issue I see with your process would be a behavioural one – it may be unsettling for an investor to watch their portfolio fluctuate more, even though rationally the set-up makes sense.
@Justin – Wow! Thanks! You’ve given me much to think about!
I really like the way you set up “John Smith’s” portfolio. At tax time, he wouldn’t have to worry about Specified Foreign Property declarations and T1135s! He wouldn’t have to deal with foreign currency calculations and he’d only have to track ACB for ZDB and VCN.
I notice that you have most of the fixed income outside the RRSP and more US & International inside the RRSP. In your 2014 white paper “Asset Location for Taxable Investors” I think it was the other way around but it was a close call. In the past, I think that the preferential taxing on capital gains outweighed the taxes on foreign income so it made sense to keep foreign equity outside the RRSP, but I suppose capital gains will be less of a factor for the forseeable future?
@Dean – I’m glad you liked the asset location changes – the ETF product selection has definitely improved over the years (as well as most brokerages now offering US dollar RRSPs), so my process has changed along with it.
In regards to the “Asset Location” white paper, you are correct that it was a close call. Had there been more tax-efficient bond ETFs available during the period analyzed, it could have easily swung the other way (and likely would have). I’m less inclined to pass judgment on the particular asset location decision made (as I feel that it’s not possible to know the optimal choice in advance). Even if an investor chose a naïve approach of holding the same asset classes in each account, hopefully these posts will show them that they can still improve the tax-efficiency of their overall portfolio with a few product tweaks.
Thanks so much Justin for the John Smith portfolio! Very informative.
Like Dean, I have maxed out my RRSP and TFSA and most of my portfolio in my corporate CCPC taxable account.
But, like Dean, I also based my portfolio on your white paper ‘Asset Location for Taxable Investors’.
So based on your paper, my first step is to favor bonds in my RRSP and to favor Canadian equities in my corporate taxable account.
2nd step: The US equities and international equities are put where there is room left in my registered accounts. Then they are spilled over my corporate taxable account. But I favor international equities in my registered accounts because they are less tax efficient based on their higher dividend yield.
3rde step: In the near future, when I have to spill over my fixed income portion in my taxable account, I’ll buy HBB or GICs or ZDB.
Does this make sense?
Seeing your John Smith portfolio, most of the bonds are in the taxable account and equities (US and international) are in RRSP, as opposed to your white paper. Is there a reason for this change of strategy?
@D – As Justin mentioned, new & improved ETF product selection has made it possible to change these old rules of thumb. I’m fairly certain that Gordon Pape has always said to put fixed income in RRSPs first. This made sense when all of the income was 100% taxable if held outside RRSPs. But now there are some tax efficient fixed income ETFs…
HBB in particular seems ridiculously tax efficient – a bond fund that has no distributions so no tax paid until it’s sold and then it’s taxed as if it were a capital gain??? Sooner or later the CRA will probably close the loophole that allows this. Otherwise it would be a no brainer to hold all fixed income in HBB in a taxable account.
ZDB I’m not as familiar with but last years spreadsheet from CDS Innovations seems to show that distributions are 81% income, 9% return of capital and 10% capital gain. If held outside a RRSP tax would only be paid on 86% of the distributions and if I remember correctly ZDB also outperformed the other commonly picked bond ETFs. That monthly return of capital would probably drive me crazy after a while if I had to track ACB on a spreadsheet though.
I didn’t do the calculations for VAB, but a quick glance at the CDS spreadsheet showed that the distributions are nearly all income with very little RoC or capital gains so it wouldn’t make sense to hold VAB outside a RRSP.
So IF (& that’s a big IF) US & International ETFs are going to have higher foreign income (that would normally be taxed at 100%) than a bond fund (with distributions taxed at say 86%) then it can certainly make more sense to hold these in an RRSP before bond ETFs. The only thing I can see throwing a monkey wrench into the works is if the US & International ETFs had such significant capital gains that would make it more advantageous to have them outside a RRSP (so the capital gains would be taxed on 50% instead of 100%) It’s at this point that my brain explodes due to all the complexity.
Personally, I’m mostly stuck with what I have since selling investments in my taxable accounts would trigger capital gains & taxes that would probably offset any advantage to rearranging things.
@Dean – if you’re concerned about tedious adjusted cost base calculations, I’ve recently upgraded to the new service offering at http://www.adjustedcostbase.ca – you can pay them $39 per year, and they give you the ability to import all of the return of capital and reinvested distribution information for your ETFs. I signed up for it, and so far have been very impressed.
For a 2015 after-tax comparison of the plain-vanilla broad-market bond ETFs vs. ZDB, please feel free to read my post: https://www.canadianportfoliomanagerblog.com/dont-discount-zdb-just-yet/
@D – corporate taxable accounts throw another issue into the mix. The refundable dividend tax credit does not work as well for foreign income as it does for Canadian income – you only get about 14.52% of a refund when you pay out a dividend (whereas for Canadian income, you receive about 26.67% back) – I believe the amount is higher for the 2016 tax year, but it’s still not as good. For corporate taxable clients, I try to hold as much international equities in an RRSP first, then US equities, and then hold the remaining US equities in the corporate account if required (you could consider holding HXS in your corporate account for US equities, if you are comfortable with the swap structure – this would alleviate the dividend refund issue).
As I mentioned in a past response, there are a number of reasons for the change of strategy, but mainly it is because there are more tax-efficient bond ETF products available, and USD RRSP accounts are readily available to use the Norbert’s gambit strategy to cheaply convert currencies in the RRSP accounts. I have to stress again that this is just a starting point – I often change this asset location decision based on the individual client’s situation.
Will there be a Part 3? I’d like to see what the perfect portfolio would look like spread over Taxable, TFSA and RRSP accounts when the TFSA/RRSP limits are maxed out. For example, if there was $400k in RRSP, $50k in TFSA $550k in Taxable what would the portfolio above look like?
I think it’s generally recommended to put income investments in RRSP first, so presumably the RRSP would hold $400k VAB and the VCN & VXC would be mostly in the taxable account and $50k of something (VCN? VXC?) would be in the TFSA.
I’d like to learn more about optimum asset locations, so any advice or book recommendations would be greatly appreciated. I’d consult a CFP but the last one I talked to knew very little about ETFs.
@Dean – although the asset location decision can be fairly investor specific, I tend to hold Canadian, U.S., and international equities in the TFSA account (all Canadian-domiciled, making sure that the international equity ETF that I’ve chosen holds the stocks directly). My reasoning for the even split – I have no idea which asset class will result in the highest growth over the long-term, so I don’t want to just guess and be completely wrong. Once the Canadian ETF providers start holding the underlying emerging markets stocks directly, I will likely allocate a portion of the TFSA to emerging markets equity ETFs as well.
Hey Justin, just curious how you chose the ratios in the John Smith portfolio for equities: CAD/US/Dev/EM 20/20/16/4. Wouldn’t something closer to their global market valuations make more sense: 6/30/18/6 (assuming 40% is in bonds)?
Second, I’m thinking how would your rationale apply to a similar scenario, but fewer bonds and allocations somehow proportional to market valuations, e.g. CAD/US/Dev/EM 8/40/24/8, CAD-bonds 20. In this case it would be difficult to fill the non-registered account with only CAD.
@Andrei – there are many reasons for overweighting Canada relative to its market cap weight in the world (which is about 3%), such as avoiding currency, tracking error and behavioural risks, and receiving tax advantaged dividends. However, too much overweighting can lead to more risk within the portfolio, which Vanguard Canada discusses in their white paper: https://www.vanguardcanada.ca/documents/global-equities-tlor.pdf
On page 6 of the report, they show historically that the lowest risk balanced portfolio overweighted Canadian stocks by 30% (relative to its market cap weight) – adding this to the current market cap weight of Canada gives us 33% (or one third). This is why I have chosen a 20% target allocation to Canadian stocks in my balanced portfolio (it is one third of the 60% overall equity allocation). There is no way of knowing in advance if this will be the optimal weight, but it is a good place for investors to start.
The remaining global equity component could be allocated according to their world market cap weight (this would equal about 55% to US stocks, 35% to EAFE stocks, and 10% to emerging markets stocks) – this is precisely how ETFs like XAW and VXC are weighting the global countries. In a balanced portfolio with a 40% allocation to global stocks, this would be equal to about 22% in US stocks, 14% in EAFE stocks and 4% in emerging markets stocks (you’ll notice that this is fairly close to the weights I use: 20/16/4).
For your second question, I would fill the registered up with international and emerging markets equities first (US-listed) as they have higher dividend yields and are more tax-inefficient than US equities. I would then hold US equities in the registered account next (US-listed), if there was still some room. If I ran out of room, I would hold VUN (or XUU) in the taxable account (Canadian-listed, to avoid additional reporting requirements and currency conversions). Again, all of this will depend on the investor’s particular situation.
@Justin – Thanks for the explanation, makes perfect sense now! One last question regarding RRSP.
According to your last white paper  and a previous post , there is basically no difference between holding IEFA (US-listed) vs. XEF (CAD-listed) with regards to withholding tax: 0.25% vs. 0.26%. Is there a reason for choosing IEFA in this case for John Smith? Actually, strictly from a withholding tax perspective, in a taxable account, XEF has 0.00% drag while IEFA has 0.25%. However I’m assuming that capital gains are not taxed that favorable (compared to CAD equity) so developed market are best kept in registered accounts.
Regarding emerging markets in RRSP, makes sense to go with IEMG (0.28%) instead of XEC (0.63%).
@Andrei – IEFA would still have a lower expense ratio than XEF (by about 0.10%). However, if an investor is purchasing IEFA in their RRSP account, they need to consider that the cost of currency conversion using Norbert’s gambit can add about 0.20% in expenses each way, so the holding should be a long term one. In a taxable account, XEF would generally be the better choice (you avoid the annual 0.26% FWT drag, and you avoid the currency conversion costs – all at an additional annual expense ratio cost of only 0.10%).
Capital gains on IEFA or XEF are taxed the same way as capital gains on Canadian equities in a taxable account. The higher dividend yield on international and emerging markets equities is one reason to favour these asset classes in your RRSP accounts (instead of Canadian or U.S. equities).
Until ETF product providers hold the underlying emerging markets stocks directly, the US-listed versions will still be more tax-efficient in an RRSP account (so IEMG would be cheaper than XEC, as long as you keep your currency conversion costs down).
Thank you, Justin. I appreciate your reply.
I had read that article previously and do hold some BXF, but approximately 3x as much VSB in taxable account. Taking into consideration the difference in fees, and that I am not fortunately enough to be anywhere near the highest tax bracket, I wonder if this would be a significant/worthwhile change. I know you often have worksheets for such calculations to assist us in making decisions on various situations, would you have one in this instance?
Thanks again, for your help!
@Lyla Willows: Unfortunately, I do not have a calculator for this specific request, but I would estimate that for an investor with a more modest marginal tax rate of 20.05%, the after-tax expected return of BXF vs. VSB would be about 0.70% and 0.47% respectively (not including any benefit from the capital loss of VSB, which could make the difference a bit smaller). Depending on the size of the holdings, this could still add up to significant tax savings. Another alternative if you do not require liquidity would be to build a 1-5 year GIC ladder (which will generally have higher yields than either BXF or VSB, and yet still be more tax-efficient than premium bond ETFs).
Just learning here…would this same logic apply to VSB?
@Lyla Willows – you are correct! VSB is also very tax-inefficient in taxable accounts, due to the same premium bond issue as VAB. I tend to use the First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF) in its place (or a ladder of 1-5 year GICs, if liquidity is not a concern): https://www.canadianportfoliomanagerblog.com/bxf-tears-a-strip-off-competitors/
Yes, wouldn’t HBB be a better choice, if one is comfortable with a swap-based etf? There is the additional advantage of not paying the capital gain until you sell HBB, instead of paying annual interest in a taxable account.
Also, what about a high yielding GIC as an alternative in a taxable account?
@D – I would expect that a 5-year GIC yielding about 2.4% would have a similar expected after-tax return to HBB (for an Ontario resident in the highest tax bracket), so this could certainly be a much simpler option for taxable investors. It would have less term risk and low default risk (if kept within CDIC limits), but it would be illiquid. I tend to build a ladder of GICs for many of my clients, and combine them with a tax-efficient bond ETF (like BXF or ZDB), for rebalancing purposes and unexpected calls on capital from clients.
Wouldn’t HBB be even better than ZDB in this example? Although ZDB had a before tax return of 3.6% compared to HBB’s 3.19% in 2015, for an Ontario resident in the top tax bracket I’m calculating that after tax the return would be 2.23% for ZDB vs. 2.4% for HBB. This is assuming buying at the beginning of the year and selling at the end of the year to take capital gains into account.
@Aaron – I would expect that HBB would have an expected after-tax return (for an Ontario resident at the highest rate) going forward of about 1.10% (not including the benefit of the tax deferral). I would expect ZDB to have an expected return after-tax of about 0.80%. For those investors who are comfortable with the swap structure and counterparty risk this could be an option (but they should be realistic, and understand that it’s likely only a matter of time before this structure is shut down).