Welcome to 2017! Last summer, I launched our ongoing series of 25-year financial reflections – sharing part 8 today. While an early version of the firm got underway even sooner, February 2017 represents our official 25-year anniversary of The McClelland Financial Group. Not only did we start commemorating the milestone a little early, we plan to keep celebrating throughout 2017! Stay tuned for additional reflections … and maybe a few other fun surprises before the year is out.
As I covered in my last 25-year reflection piece, “Tax-Efficient Essentials“, there’s one advantage to having modest retirement savings: It’s relatively easy for you to manage your money effectively and tax efficiently by setting up a simple balanced fund within each of your registered (tax-sheltered) accounts.
Once you exceed the ability to tax-shelter all of your assets in registered accounts, you’ll want to open non-registered (taxable) accounts in which your savings can continue to accumulate, and hopefully also grow. Of course more money is a good “problem” to have! But, with more accounts to juggle, you’ll also want to take your tax-efficient investments to a higher level.
The magic term here is: asset location.
What Is Asset Location?
Let’s begin by noting that asset location should not be confused with asset allocation.
- Asset allocation is dividing up your money among stocks, bonds, real estate and cash, no matter what account the money lives in. Allocation helps you manage the market’s overall risks and expected returns.
- Asset location is deciding where to locate your allocations to stocks, bonds, real estate and cash between your taxable and tax-sheltered accounts. Asset location helps you maximize your overall tax efficiency.
When I meet with families for the first time and take a look at their existing portfolio – i.e., their total wealth – I often find a mostly random collection of accounts that have been cobbled together over the years: a TFSA here, an RRSP there, spouses’ assets haphazardly arranged.
While even a disorganized portfolio is far better than not having one at all, imagine how much more tax-efficient your investments could be if you (or an experienced advisor) ensured that your most heavily taxed investments were deliberately located within your tax-sheltered accounts, to minimize the damage done?
Applying Asset Location in Real Time
In theory, asset location makes a lot of sense. But until I mention it, most investors have never heard of it, let alone implemented it into their planning. That may be because, in real life, applying and managing it can get a little complicated.
Identifying opportunities. First, there is only so much room within your tax-sheltered accounts. After all, if there were unlimited opportunity to tax-shelter your money, we’d simply move everything into that balanced fund I mentioned and be done with it. In reality, challenging trade-offs must be made to ensure you’re making best use of your tax-sheltered “space.”
Assessing your bigger picture. Second, it’s not just about tax-sheltering your assets; it’s about doing so within the larger context of how and when you need those assets available for achieving your personal goals, as well as how to apply the general principles of asset location to your specific tax-related circumstances. Arriving at – and maintaining – the best formula for you and your unique circumstances involves many moving parts.
Maintaining what you’ve built. Last but not least, asset location is rarely a set-and-forget activity. As your own goals, the market and government regulations evolve, your portfolio may require ongoing attention to remain as tax-efficient as possible.
Why You (Probably) Need an Advisor To Assist
Ongoing professional advice from someone who is familiar with these and other tax-planning intricacies can go a long way toward making the most of your asset location opportunities. That includes ensuring that you, your financial planner and your tax specialist are all in this together. Here are some of the ways your advisor can assist:
Adding tax-efficient planning to your overall planning. Before locating your assets, you’ll want to determine your proper asset allocation based on your unique goals and risk tolerances. Then you can determine where those holdings should reside for tax efficiency.
Advancing your goals and timeframe. Is retirement near or far? Do you want to leave a legacy? Are your circumstances likely to change in the next few years? There may be withdrawal, estate planning or other needs that override optimal asset location.
Managing tax-sheltered accounts. What are your various tax-sheltered account opportunities: such as TFSAs versus RRSPs? How much room do you have in each for holding assets, and which types of holdings in which kinds of accounts are going to give you the most tax-efficient bang for your buck? How does evolving tax code impact your plans?
Considering other tax-planning needs. There may be other tax-planning considerations that impact the general practice of locating your least tax-efficient holdings in tax-sheltered accounts. For example, with stocks held in taxable accounts, you can generate tax efficiencies by harvesting capital losses against capital gains, taking foreign tax credits, donating appreciated shares to charity and experiencing a step-up in basis upon inheritance. While these opportunities have more or less importance depending on your goals and circumstances, they become unavailable for stocks held in tax-sheltered accounts.
An Asset Location Illustration
Each investor’s optimal asset locations are unique to his or her particular needs. But it may help to consider an illustration in action for, say, a couple who is saving for retirement, which remains a decade or more away.
Unless you’re ahead of schedule on building your nest egg, this scenario often calls for a generous allocation to stocks, in pursuit of their higher expected returns (compared to bonds). We may even tilt the portfolio toward equity asset classes that have exhibited even more risk (compared to other stock asset classes), in pursuit of their even higher expected returns. These can include asset classes such as emerging market or small-company stocks, which tend to be less tax-efficient than their domestic, blue-chip counterparts (although more tax-efficient than bonds).
Given a mix of registered and non-registered accounts, I typically would recommend putting your most conservative investments – your bond/fixed income and Real Estate Investment Trust (REIT) holdings – into your registered, tax-sheltered accounts.
Why so? Typically, bonds generate interest income, which is taxed at usually higher ordinary tax rates, while stocks generate capital gains income, which is taxed at usually lower capital gains rates. These different tax treatments tend to make bond and REIT income less tax-efficient, so you want to avoid holding them in your taxable accounts. (And, by the way, it matters not whether your stocks, bonds and REITs are held individually or within a fund. The tax man cometh, either way.)
For your non-registered (taxable) accounts, the top priority is usually your Canadian stock holdings, so you can claim any available dividend tax credits. Next up, we try to include U.S. stocks, so we can recover some of the foreign tax withheld on their dividends. Last up come other international stocks, because of their capital gain earning potential and relative tax efficiencies (at least compared to bonds). The rest of your least tax-efficient stocks may end up in either type of account, depending on what space remains in each.
Whew! That’s a lot to take in. Here’s a quick summary of your typical placement priorities.
|An Asset Location Illustration|
|Registered (Tax-Sheltered) Accounts||Non-Registered (Taxable) Accounts|
|Bonds (fixed income)||Canadian stocks|
|REITs||U.S. and other international stocks|
|Relatively tax-inefficient stocks||Other relatively tax-efficient stocks|
Lifelong Asset Location
Optimizing your asset location mix is important throughout your investing days, but it can be especially important in your retirement years, when your income tax can play a big role in how much money you get to spend every year.
That’s one reason why it’s important to routinely consider asset location in your overall wealth planning. It’s also important to emphasize that the principles I’ve covered here are just the basics. (If you have a trust or corporate accounts, it gets even hairier!)
Bottom line, everyone’s situation is unique, and should be uniquely managed. But if you’ve never managed your investments for tax-efficient asset location to begin with, you may well be missing out on some of the money that could have been yours to keep. Give us a call to find out more.