Asset location refers to the way in which assets are divided between taxable accounts and tax-advantaged accounts to maximize a portfolio's after-tax returns.
It also refers to how assets are divided among the different types of tax-advantaged accounts, such as a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA), given their specific tax treatment.
Over time, taxes can have a substantial impact on the value of an investment. That's why asset location is such an important component of any comprehensive financial plan. By purchasing tax-inefficient investments in tax-advantaged accounts and limiting taxable account holdings to tax-efficient investments, investors can potentially retain a greater portion of their after-tax returns. And those incremental differences in return can have a powerful compounding effect over the long run.
An obvious starting point for maximizing tax efficiency is to place as many assets as possible in tax-advantaged accounts. However, contribution limits for tax-advantaged accounts may require at least some portion of an investor’s portfolio to be placed in taxable accounts.
When deciding where to place those assets, it's important to understand the potential tax treatment of any interest, dividends or capital gains that a particular investment is likely to produce.
Interest income and dividends from non-Canadian stocks are generally fully taxed at an investor’s marginal rate.
Dividends from Canadian stocks are generally eligible for a dividend tax credit and thus taxed more favourably than both interest income and dividends from non-Canadian stock.
One half of an investor’s net capital gains are generally taxed at his or her marginal rate. Therefore, investors may benefit from placing funds and ETFs holding bonds or international dividend-paying stocks in a tax-advantaged account and funds and ETFs holding Canadian dividend-paying stocks in a taxable account.
When choosing between taxable and tax-advantaged accounts, investors should further consider that passively managed index funds and ETFs may generate lower capital gains for investors than actively managed funds with similar underlying assets.
In choosing among accounts, it is also important to consider that after-tax returns may vary among the different types of tax-advantaged accounts. For instance, investors receive a tax deduction for contributions to an RRSP, but not for contributions to a TFSA. Further, with both an RRSP and TFSA, while amounts remain in an account, an investor will not pay any taxes on investment earnings and growth. However, withdrawals from an RRSP, including amounts attributable to capital gain, are fully taxed at the investor’s marginal rate, while withdrawals from a TFSA are tax free.
Additional factors may affect an asset location decision, including the anticipated duration of an investment and an investor’s income tax rates at the time of withdrawal.