Hello everyone, and welcome to the Retiring Canada Podcast. In today’s episode, we're going to discuss Tax-Efficient Fund Placement, also known as Asset Location.
Specifically, we will cover:
1. What is Asset Location, and how does it differ from Asset Allocation
2. An example of how this is implemented
3. The key benefits of Asset Location
4. Three important considerations before implementing Asset Location changes
5. Finding the best balance to manage liquidity and tax efficiency
6. The most common error we come across
7. And, as always, a few action items for you to consider.
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Now, back to today's episode. Today, I will be discussing the tax-efficient placement of your investments within your retirement accounts, also known as Asset Location. Not to be confused with Asset Allocation.
As a refresher, asset allocation refers to the percentage of your portfolio that targets each asset class. For example, a typical 60/40 portfolio is made up of 60% equity or stocks and 40% fixed income or bonds. These represent your asset classes, equity and fixed income, and together their percentages represent your asset allocation.
Asset location takes things a step further. By managing all accounts as a single, holistic portfolio, the implementation of tax-efficient fund placement, known as asset location, becomes a possibility. This technique is especially valuable for those of you in a high marginal tax bracket.
So, if we look again at our typical portfolio of 60% equity and 40% fixed income and consider each of these asset classes separately, you will discover that the tax treatment of each of these is drastically different. Because certain asset classes are more tax-efficient than others, two portfolios with identical pre-tax returns can experience significantly different after-tax returns depending on where the assets are “placed” across the various accounts comprising the portfolio.
Once we have determined the right asset allocation for a client (i.e., the percentage of the portfolio that we will target for each asset class), we carefully consider the optimal location of each asset class to maximize the portfolio’s tax efficiency.
To be more specific, we carefully consider which mutual funds and ETFs to place in tax-advantaged accounts (RRSPs, RRIFs, Defined Contribution Pensions, TFSAs, etc.) and which to place in taxable accounts, often referred to as non-registered accounts, to minimize the difference between the portfolio’s pre-tax and after-tax returns.
Here is an example scenario I came across recently with a new client. He and his wife have ~$800,000 in investments spread across three account types: RRSPs, TFSAs, and a joint non-registered account.
In their RRSPs, they held a portfolio of traditional high-fee 60/40 mutual funds. In the TFSAs, they held GICs and high-interest savings, and in the non-registered account, they held more high-interest savings and some traditional 60/40 mutual funds.
After careful consideration by myself and my team, we determined we could build a more tax-efficient portfolio without changing their risk profile. This involved shifting more of their overall retirement portfolio’s equity from the RRSPs into the joint non-registered account and TFSAs. It called for a more prudent use of the TFSA to take advantage of tax-free growth and a shift of their fixed income investments and GICs into their fully taxable RRSP accounts.
This also required us to deconstruct their high-fee 60/40 portfolio into low-cost fund and ETF solutions that were more apt to provide the tax efficiency and cost reduction we advocate for our retirement clients.
Here is an even simpler example of asset location at work.
Let’s say you have $500,000, half in RRSPs invested in 100% equities and the other half in 100% bonds and fixed income. The asset allocation of the overall retirement portfolio is 50/50, but the tax efficiency of the portfolio is completely backward.
Since withdrawals from an RRSP or RRIF are 100% taxable as income and interest income generated from the fixed income portfolio is also 100% taxed, it would make more sense to switch the asset locations between the RRSPs and non-registered accounts to create a more tax-efficient portfolio. So, in this very oversimplified example, you would shift all of the fixed income and bonds into the RRSP, and all of the equities, which are tax-preferred, into the non-registered account.
The overall risk tolerance of the retirement portfolio wasn’t changed—it's still 50/50. However, now the end result is a more tax-efficient portfolio overall.
Again, this example is very oversimplified. I am not factoring in TFSAs, potential tax consequences from rebalancing, and client specifics like risk tolerance and income needs. So please consult with a professional before considering these types of changes.
While the key benefit to this approach is tax efficiency, there are some important considerations you need to understand before implementing tax-efficient fund placement.
First, this strategy assumes that all your accounts are being managed holistically, which rests on the assumption that all of the money in the accounts is for the same goal, i.e., retirement.
It is important to segregate some monies for short-term goals and needs separately, so as not to impact the long-term efficiency of the retirement portfolio.
Next, in order to implement this strategy, you need to be comfortable with each of your accounts getting different returns, and instead focus on the overall after-tax performance of the aggregated portfolio.
Furthermore, you need to be comfortable that the investments in a given account may look strange in isolation.
For example, if an ideal tax strategy dictates that all of the RRSP account be invested in bond funds, it may look very counterintuitive if viewed in isolation, rather than just one piece of the overall retirement puzzle.
Lastly, while perfectly optimizing a portfolio according to the framework I have discussed would sometimes suggest that all of a client’s taxable bond funds be placed in their tax-advantaged accounts, meaning their taxable account would hold only stock funds, we have learned that reality requires a slight adjustment to this approach.
Even if the client expects that all of the money within the holistically-managed portfolio will be used for the same long-term goal, a client’s goals can change quickly, and their portfolio should be flexible enough to easily allow for unplanned withdrawals.
Specifically, because stock funds are more likely than bond funds to either go down significantly in value or have material unrealized capital gains that would be realized if sold, and because any withdrawals from a clients’ portfolios would need to come from their taxable accounts for the foreseeable future, the “perfectly tax-optimized” portfolio construction could backfire should they ever need to make an unexpected withdrawal.
For that reason, it’s good practice to place a portion of bond funds in taxable accounts—doing so makes it more likely that you could liquidate some of the portfolio at any time with more confidence in the available balance and without material tax consequences.
We manage this inevitable trade-off between perfect tax optimization and liquidity considerations on our clients’ behalf.
Tax-efficient fund placement requires some upfront and ongoing effort to optimize, but executed correctly, it can be a powerful wealth-preservation strategy for retirees.
Ok, so that will do it for today! Here are your action items for today's episode:
First, I understand that this concept is quite technical and may be out of the comfort zone for most of you listening to this podcast. With that, consider checking out our Fundamental Retirement Plan by visiting our website, where we professionally implement and monitor retirement plans that utilize asset location as one piece of the retirement puzzle.
Lastly, one of the most common errors we see with regard to asset location is not utilizing the Tax-Free Savings Account (TFSA) properly. While the name of the account says "savings account," nearly any kind of traditional investment can be held in this account. For the retirement investor, ensuring this account is topped up annually and the assets located inside of the TFSA are thoughtfully considered will help to ensure a tax-efficient retirement well into your golden years.
For the links and resources discussed, please check out the link in the show notes or visit retiringcanada.ca.
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All comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of Harbourfront Wealth Management. While every attempt is made to ensure accuracy, facts and figures are not guaranteed, the content is not intended to be a substitute for professional investing or tax advice. Please seek advice from your accountant regarding anything raised in the content of the podcast regarding your Individual tax situation. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.