Looking at the asset mix of a portfolio is the easy part. Deciding how to break out where investments should be held is not so easy. Decisions about where to hold investments can have a significant long-term effect on your wealth. I believe that for wealthy Canadians, this is where some of the biggest investment mistakes occur.
Here are some key rules to follow to squeeze the most out of your investments.
Consider a basic scenario that we might use with a client:
Cash and equivalents 8 per cent
Preferred shares 27 per cent
Bonds/Convertible Debentures 5 per cent
Stocks (Growth) 60 per cent
Cash and equivalents: 2 per cent
Preferred shares: 0 per cent
Bonds/Convertible Debentures: 68 per cent
Stocks (Dividend): 30 per cent
Cash and equivalents: 5 per cent
Preferred shares: 13 per cent
Bonds/Convertible Debentures: 37 per cent
Stocks: 45 per cent
Conventional wisdom suggests that it is important to start out with a well thought out review of your overall asset mix. The next step is to maximize it for tax purposes.
If an Ontario resident has $60,000 of income, the tax rate on interest is 31 per cent, on capital gains it is 16 per cent, and on dividends from eligible corporations (most publicly traded Canadian companies), the tax rate is 10 per cent.
The above illustration outlines how to take advantage of these differences.
In the cash or taxable accounts, there is 13 per cent that would have interest income (8 per cent cash plus 5 per cent bonds). This faces the highest tax rate, and is generally to be kept to a minimum in a taxable account.
The preferred shares are in the cash account for safety, but also because they produce dividend income, which is taxed at a much lower rate than interest.
The stocks are geared more toward growth companies that may not generate any taxable income. The only tax consequence is from the gains or losses resulting when the stock is sold. For gains, this can be deferred for many years without paying tax. In addition, if someone is affected by clawbacks to Old Age Security because of their income, the growth stocks can significantly help as they would produce very little income, as opposed to other investments.
On the tax-sheltered side, we want to look at the overall asset target, and make sure that the highest-tax investments are held in a place where the tax is sheltered. As a result, almost all of the bonds are held in the tax-sheltered accounts. For the equities, we put the income-producing stocks in here rather than in the cash or taxable account. Another reason for this stock separation is that growth stocks tend to be more volatile and, in general, are more likely to see a capital loss (as well as a higher capital gain). If they are held in an RRSP, then the tax benefits of a capital loss will disappear. To be more clear, if you buy a stock for $10 and sell it for $0 in an RSP, you have lost 100 per cent of your investment. If it is held in a taxable account, at least you can use that $10 loss against a $10 capital gain. For someone in the top tax bracket, that $10 loss can be worth $2.30.
You can make an argument that high-growth companies should be held in an RSP because if there are large gains, you don't have to pay capital gains taxes. This can make sense in some cases, but makes more sense for someone younger. For someone older, this gain will ultimately turn into taxable income when withdrawn from an RSP or RIF – possibly within 10 or 20 years. If someone is younger, this capital gain can grow tax-free for a much longer period of time and provide much greater benefit before it is withdrawn and taxed at the highest rate.
Now comes the issue of Tax-Free Savings Accounts: Should they be managed the same way as an RSP in terms of sheltering taxable income?
There are two schools of thought. One is to simply shelter income in the TFSA, so you would hold bonds and cash and interest income-generating investments in the TFSA.
The other school of thought is to invest in small-cap growth stocks, the benefit being that if the stocks grow significantly, it actually boosts the total amount of TFSA sheltering room you can use in the future.
I think both make sense as long as you maintain the overall discipline around your portfolio asset mix.
The key point is that investing is all about what you keep after all fees and taxes. The hard money is made by strong investment management. The easy money is made by being tax smart. Unfortunately, too many people are leaving the easy money on the table.
Follow Ted Rechtshaffen on Twitter: @TriDelta1