Asset Location: It’s Not What You Make That Counts – It’s What You Keep!

“The hardest thing in the world to understand is the income tax.” -Albert Einstein

A central problem confronting investors is how to efficiently invest the funds held in their taxable and tax-deferred savings accounts. The problem involves making both an optimal asset allocation decision (i.e., deciding how much of each asset to hold) and an optimal asset location decision (i.e., deciding which assets to hold in the taxable and tax-deferred accounts).Investors would like to make these decisions to reduce the tax burden of owning financial assets, while maintaining an optimally diversified portfolio over time. They must do this under conditions of uncertainty as yields and tax rates tax rates are variable and unpredictable over time. Asset location is a optimization strategy that takes advantage of the fact that different types of investments get different tax treatments and have different constraints. For instance using this strategy, an investor determines which securities should be held in tax-deferred accounts and which securities should be held in taxable accounts in order to maximize after-tax returns. Some advanced mathematics has been applied to tackle this complex problem. This article will explain the basic ideas behind asset location and how it can improve portfolio performance.

Sometimes a location problem is caused by advisor error or sales commissions. My first experience with asset location was when I encountered a portfolio that contained clone mutual funds. These clone funds were financially engineered to make foreign funds eligible for RRSP’s. At the time, RRSP’s had foreign content percentage restrictions. The problem was that the broker had bought them for a taxable account, not a registered account. In effect, the client was paying about 0.50 % more MER for a fund that was located in the wrong type of account.

Another example turned up recently where a fund salesperson had loaded up a RRIF with DSC funds. While great for commission -driven “advisors’, such a scheme exposes a senior to early redemption penalties each year because RRIF rules require minimum annual withdrawals. In that case the senior was 86 years old, so she would have had to live to 93 to extract herself from the DSC early redemption fee exposure. Even at death, DSC fees must be paid. Clearly, asset location is not just about taxes. Similar problems have arisen with segregated funds. These funds provide capital guarantees, but only if the fund is held to maturity. The maturity date is the date at which the maturity guarantee is available to the contract holder. Holding periods to reach maturity are usually 10 years, so a RRIF may not be the best location for such funds.

One key point – the tax considerations should not be the driver of your asset allocation. The first step should be determining what type of investment (cash, stocks, bonds) you want this money invested in. The next step is to figure out what type of account (RRSP, RESP, TFSA, taxable account) it should be located in. Easier said than done.

Who Benefits From Asset Location?

For investors to benefit from a location strategy, they must have investments in both taxable and tax-deferred accounts. Tax-deferred accounts include RRSP’s, RRIF’s and TFSA’s and the like. Investors with assets split between taxable and tax-deferred accounts and with similar asset mixes will get the largest benefit from asset location. For example, an investor with an asset mix of 40% fixed income and 60% equity will achieve the maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of total assets. In principle, moving all fixed-income investments into the non-taxable account and all equities into the taxable account would provide the maximum benefit, all else being equal. And that’s the catch- it’s rare that all else is equal. Each individual has unique circumstances and constraints. That’s why investors and their advisors need to carefully think through where assets should be located.

One of the worst examples of asset mis-location involved a RESP account. Either hungry for lucrative commissions or just incompetent, a broker recommended a LSIF for a RESP that would soon need to be drawn down as the child was approaching university age. LSIFs provide venture capital to small and medium-sized business enterprises; the funds allow investors to pool their resources to invest in small businesses in need of funds for growth. Investments in LSIFs qualify for the federal LSIF tax credit, and where applicable, an additional provincial tax credit. For federal income tax purposes, an investor purchasing shares in a LSIF is entitled to a credit of 15% of up to $5,000 of the cost of the shares, for a maximum credit of $750 per year. In those provinces that also provide credits, it is possible to double up the total credit. As an inducement to investors to hold for the long run, the government requires that investors hold onto their investments for a minimum period of 8 years. If the shares are sold before the hold period is up, the investor must forfeit the tax credits that were previously claimed. Not only was the investment unsuitable, it created a serious liquidity problem because of its location in a RESP.

Typically, investors who use a balanced investment strategy consisting of equity and fixed-income investments can get the most benefit from asset location

If an investor is withdrawing funds from tax-deferred accounts or will be doing so in the near future, the benefit of an asset location strategy is greater than it would be for younger investors with many years left before they will start withdrawing funds. As an example, assume an investor made $20,000 in capital gains and dividends in a traditional RRSP during the past year and withdrew the same amount. At the top marginal tax bracket, these earnings would be taxed at 46%, leaving the investor with $10,800. If the investor made $20,000 in capital gains and dividends in a taxable account, the tax would have been far less because capital gains are taxed more lightly than regular income and dividends from Canadian corporations benefit from the Canadian dividend tax credit.

We’ve seen cases where a RRSP account makes no sense at all. Investors must never forget the very important tax and estate issues associated with RRSP's /RRIF’s when withdrawal time comes around. For instance, the GIS clawback will hurt people with less than $100,000 in retirement assets hard. (see CD Howe Institute Backgrounder No. 65 New Poverty Traps: Means-Testing and Modest-Income Seniors available at
www.cdhowe.org/pdf/backgrounder_65.pdf) .One weeps for those Canadians who follow the undifferentiated advice to save in RRSP’s. For many lower-income Canadians, RRSPs are a terrible investment. Only when more Canadians are aware of the perverse treatment of lower-income citizens’ savings will Ottawa be forced to develop measures that reward, rather than punish, their savings efforts .Tax experts and bureaucrats know that locating assets in such an account will be of almost no value.

How Asset Location Provides better after-tax returns

A typical investor with a balanced portfolio consisting of 60% stocks and 40% bonds might hold investments in both taxable accounts and tax-deferred accounts. Although the investor's overall portfolio should be balanced, each account does not need to have the same asset mix. Creating the same asset allocation in each account ignores the tax benefit of properly placing securities in the type of account that will assure the best after-tax return.

Locating a stripped coupon bond in a non-registered account is a bad idea from a tax perspective. Here's why. The Canada Revenue Agency treats the imputed interest that the bonds earn every year as current income. As such, it is subject to tax in that year, even though you have not received any money and won't actually see any return until the bond matures. So you are paying tax years in advance, on money you don't have. Professional advisors only recommend these bonds for RRSPs because of their predictable return and fixed maturity date. Most don't like them for RRIFs because there is no cash flow.

How a security is taxed is thus a key factor as to where it should be located. Capital gains and Canadian corporation Dividends get favourable treatment. Interest income gets taxed the most heavily. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 46%) if withdrawn from a traditional RRSP or other type of retirement account where taxes are paid on the withdrawal of funds. However, contributions to a RRSP are deducted from your taxable income so there is a trade-off here depending on several factors including your taxable income and tax rate. For an idea of the calculations involved in trading off a contribution to a RRSP vs. an taxable account and a paydown of a mortgage visit
http://www.efficientmarket.ca/article/RRSP_vs_NON_REGISTERED

Fixed-income investments, such as bonds and GIC’s generate a regular cash flow. In 2009, these interest payments are subject to the same ordinary income tax rates. A tax-deferred account provides investors with a shelter for this income. Of course if you need the income for living expenses you may have to locate these in a taxable account. This is yet another constraint when trying to optimize asset location.

Criteria for achieving Optimal Asset Location

Asset location, although it provides for lower taxes, is not a replacement for asset allocation. Only after you determine the proper asset mix for your portfolio can you then locate those investments in the appropriate accounts to minimize the tax drag on your investments. (For more information, see Choose Your Own Asset Allocation Adventure and Five Things To Know About Asset Allocation.)

The best location for an investor's assets depends on a number of different factors, some of them behaving in an unpredictable manner over time. However, there are some general principles for the types of investments that are best-suited to each type of account.

Using Taxable Accounts Efficiently

Generally, tax-friendly stocks should be held in taxable accounts because of their lower capital gains and dividend tax rates and the ability to defer gains. Riskier and more volatile investments belong in taxable accounts both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a recognized loss. Index funds, as well as ETFs, are valued for their tax efficiency and should also be held in taxable accounts. (For related reading, check out Selling Losing Securities For A Tax Advantage.)

Optimizing the use of Tax-Deferred Accounts

For most retail investors, bonds and GIC’s should be held in tax-deferred accounts such as RRSP’s. Any mutual funds that generate high yearly capital gains distributions also belong in tax-deferred accounts. Low portfolio turnover funds may be suitable in a taxable account. In a 2003 study, Moshe Milevsky, an associate professor of finance at York University's Schulich School of Business, concluded that, on average, 1.35% is lost to taxes from annual distributions alone. Before tax, the average annual return for mutual funds with a 10-year history (343 funds) was 9.01% percent. After distributions, the average return dropped to 7.66%. Furthermore, tax is triggered not only by the fund manager's activities, but also when investors dispose of the funds. On average, an investor disposing of a fund stands to lose another 1.0%. A big problem in the Canadian fund industry today is that it discloses only pre-tax returns and not after-tax returns. This may change one day, but for now the information available about the tax efficiency of funds is limited. http://www.ifid.ca/pdf_workingpapers/WP2003.pdf The Impact of Personal Income Taxes on Returns and Rankings of Canadian Equity Mutual Funds. Mutual funds distribute all income and capital gains to unitholders, usually at the end of the year. They cannot distribute losses but can use them to offset gains in future periods. NOTE: Never forget the role MER’s play on long-term mutual fund returns- much of the time it’s the single most important determinant of a balanced portfolio’s performance.

I recall one disturbing case where a mutual fund salesman levered up an investor to buy more mutual funds for her RRSP. The majority of the funds related to technology, the internet and e –commerce. When these funds tanked in 2002, the investor decided to sell them at a huge loss. The first problem was that interest on RRSP loans was not tax- deductible despite the salesman’s assurances that it was. Further, because she had located these highly volatile funds in a tax-deferred account, she could not deduct the capital losses from capital gains. Finally, because she was no longer contributing to her RRSP, the account’s capital base had taken a virtually irrecoverable jolt.

Note also that dividend and interest income for U.S stock/bonds and U.S. dollar denominated mutual funds in an RRSP will be unilaterally converted to Canadian dollars. Investor advocates argue that this forced currency conversion is not required by the CRA and that these conversions include excessive, opaquely disclosed fees, impairing returns. Depending on personal circumstances and the nature of the securities, it may be advantageous to keep some U.S. dollar investments in an U.S. dollar taxable account.

What to invest in the TFSA?

What to invest in the TFSA is case- specific on every individuals. Generally, a TFSA account should be used to hold investments that generate the most taxable income. Interest income is 100% taxable, whereas capital gains are only 50% taxable. Therefore, the TFSA can be utilized more effectively by holding investments that generate interest income and leave the other investments in your unregistered accounts. However, current ultra-low interest rates on T-bills, GIC’s, CSB’s and money market funds may cause this approach to be dysfunctional. Further, there is a potential advantage in putting securities in the TFSA that can generate a large capital gain. For instance, if you purchase a stock at $100 and sell it at $1,000 and withdraw it all, $1,000 (not $100) will be added to your TFSA contribution room in the following year. This can allow you to put additional funds into your TFSA and earn more tax-free investment income. Note however that any capital losses cannot be netted against capital gains in a TFSA (or a RRSP for that matter) and transaction costs can’t be deducted .The latest rules on TFSA’s can be found at http://www.cra-arc.gc.ca/tx/rgstrd/tfsa-celi/menu-eng.html . Like other tax rules, these too change over time and in fact, recently did

Conclusion

Asset location is a strategy that determines the proper account to place investments in to get the most favourable tax treatment overall and avoid other pitfalls. It is not a replacement for asset allocation, but it adds to the overall after-tax return. It’s also a strategy trying to deal with many time variable parameters simultaneously. It isn’t a trivial problem to solve.

The best location for a particular security depends on an investor's personal and financial profile (taxes, cash flows), prevailing tax laws, investment holding periods, liquidity needs and cost to liquidate, account characteristics and constraints and the tax and return characteristics of the underlying securities. For most retail investors, basic ideas will do. Just avoiding obvious mistakes will yield much of the potential after-tax gain. For complex scenarios, the services of a professional financial planner will be required. Recognize too that changing Government policies and tax rules as well as portfolio rebalancing necessitate periodic review of asset location and related policies.

For those who want exposure to a methodology for location optimization visit www.irebal.com/docs/AssetLocation.pdf . The authors of Asset Location: A Generic Framework for Maximizing After-Tax Wealth advocate putting the high-return tax hogs into IRAs (a U.S. RRSP counterpart). Included in this category are REITs, commodities, and active large-cap domestic-stock funds that generate high yearly capital gains distributions. The American researchers determined that higher-performing, tax-efficient assets belong in taxable accounts. The model would need adjustment to fit Canada’s tax regime but the principles and techniques are worth reading about. An important finding in this study was that by using optimal asset locations, investors may increase their after-tax returns by an average of 20 basis points (0.2%). In Canada, the results would be much larger due to our higher tax rates.

Rick Ferri in his All About Index Funds argues that, from a psychological point of view, each account should be split up so that it has the same asset allocation as your whole portfolio. Ferri makes the case that, if one account were to be entirely bonds and another entirely stocks, many investors would have a hard time considering them as part of a broader multi-account portfolio, rather than separately. (And, therefore, rather than deriving the psychological comfort that usually come with having a diversified portfolio, the investor would be watching whichever account is comprised entirely of stocks and panicking whenever it goes down.) .Anytime there’s an investment math vs. behavioral finance debate, I’m reluctant to declare one option as “best.”

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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Personal Opinions & Recommendations Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.