Editor's note: This article has been revised by the author since original publication, and republished on July 14.
Though my current portfolio started about three years ago in February 2011, my investing journey started long before that.
I have always looked after the family's finances. This makes sense for a stay-at-home mom who can get to the bank during working hours and does most of the shopping. I took that responsibility seriously and despite having little margin in the finances, I would give a monthly report based on Robert Kiyosaki's four quadrants of where our finances were at and what was spent to my husband. He would humor me by nodding and smiling, confident that I was being as responsible as possible. After the children were off to university, I worked as an assistant to a financial advisor. My husband's income took a big jump at the same time as most of our savings was lost. Those monthly reports became even more important. We did not want the increase in income to just disappear into household spending, and I had caught the vision of a secure retirement living off the dividends of our investments from hanging out here at Seeking Alpha. I soon came to understand that our family's biggest expense is taxes and I began to study taxes in the fall of 2012.
The combination of learning taxes and being exposed to the structure of different accounts and portfolios from my work for the financial advisors has been invaluable to me as a self-directed investor. As the portfolio has grown across several types of accounts it has become more important to make use of tax-efficient asset location, especially in the earlier stages of portfolio management.
Many investors have several accounts, each allocated with the same holdings and approximate percentages. I have chosen to view all of our accounts as a whole portfolio in order to maximize the tax advantages of each type of account. Certain types of holdings are best suited tax-wise to certain accounts and the majority of my transactions in the past quarter have served to relocate and add to current holdings.
Here are the six rules of asset location that I apply to my portfolio.
1. Slow and steady in registered retirement (IRA, RSP)
2. REITs in registered retirement.
3. Foreign companies with dividends not in tax-free (Roth, TFSA account).
4. Higher growth in tax-free account.
5. Volatile holdings in non-registered (also called "open" or "taxable") to harvest losses and donate winners.
6. High-yielding Canadian dividend in non-registered (for Canadians).
I currently manage our portfolio across five accounts: my husband's registered retirement, my husband's spousal registered retirement, my husband's tax-free, my tax-free and a non-registered account in my name only.
In the beginning, with less than $10,000, we only had my husband's retirement account. All contributions were added to it so there was no need to consider how best to locate holdings. It is only in the last calendar year that all five accounts have existed and decisions needed to be made about where to contribute and what to hold where. I have been surprised at the level of complication and frustration this has caused.
First let me explain in more detail the application of the rules to the accounts.
1. Slow and steady in registered retirement (IRA, RSP)
As all funds in a government registered retirement account will be taxable upon withdrawal, this is not the best place to put high growth or trading names. Of course, I would gladly pay taxes on growth rather than have no growth in the portfolio, but since the purpose of asset location is to maximize tax savings, slow and steady belong here.
Different types of income are taxed differently: interest and distributions are fully taxable, capital gains are only taxed on 50%, and dividends of Canadian corporations (in Canada) are tax advantaged. But none of this applies in registered accounts. The tax advantages of capital gains and dividends are lost. This means that to save on taxes, fully taxable interest-bearing investments like bonds, GICs or CDs are better held in registered accounts and stocks with capital gains should be in non-registered or tax-free accounts.
2. REITs in registered retirement
REITs can be tricky and taxation rules vary depending on the REIT. Portions of their dividends may be designated as return of capital which is added to the cost basis, or distributions of interest which is fully taxable or just treated like regular dividends. Since they tend to be slow and steady, I have chosen to wash my hands of the whole mess and keep them in the spousal retirement account, safe from tax issues, for now. This is, as of yet, a small account; the only thing it holds are my two REITs. Yes, I am giving up the Canadian Dividend Tax Credit (described below) but I am also giving up any other possible paperwork.
3. Foreign companies with dividends not in tax-free (Roth, TFSA) accounts.
Due to tax treaties related to retirement accounts between the US & Canada, dividend payments are exempt from withholding taxes in registered retirement accounts. In non-registered accounts a 15% withholding tax is applied. For Canadians this means US holdings in RSPs are exempt from withholding and for Americans this means Canadian holdings in retirement-based traditional IRAs are exempt.
The tax treaty does not extend to the tax-free accounts (Roth & TFSA) so withholding tax will be taking from your foreign dividend payments there. To add insult to injury this withholding tax is not claimable on your tax return.
If withholding taxes are taken from dividends paid in non-registered accounts, the taxes paid can be claimed on your tax return as tax already paid, but this is not true of withholding tax within tax-free accounts.
Since I have, so far, only a small non-registered account, I keep my foreign (in my case, US) companies in the retirement account.
4. Higher growth in tax-free (Roth, TFSA) account
Tax has already been paid on the contributions you make to the tax-free accounts so those contributions are allowed to grow and earn without any future tax consequences at all. (TFSA stands for Tax-Free Savings Account). Since the growth in a tax-free account is tax-free, it is the place to put your best growth ideas to maximize your tax savings. This is especially true if you expect your income to be higher later on or wish to have a more tax-free retirement. The benefit of a more tax-free retirement is to not only avoid taxes, but to avoid "clawbacks" which are the government keeping part of your retirement benefits that are based on income. The goal is to have income, just not taxable income!
If you do not have a significant income now (like myself) and are in a low- or no-tax bracket there is far less of an advantage to putting a significant amount of money into an retirement account, but the ability to use the tax-free Roth or TFSA will help. I encourage young people to fill their tax-free accounts as much as possible, as soon as possible. Being free from the constraints and rules of the retirement account can be helpful as life events happen over the years, but if the easy access of a tax-free is tempting for small, more regular things, you would be better to use the binding nature of the retirement account.
In contrast, for a higher income person, in a higher tax bracket, (like my spouse) the advantage of receiving a tax refund at his current tax bracket, and then likely needing to pay withdrawals in retirement at a lower tax bracket allows him to capture a possible spread of 7%. This makes contributing to the registered retirement accounts more useful.
5. Volatile holdings in non-registered (also called "open" or "taxable")
Non-registered accounts are your average, plain vanilla accounts. They do not have any special considerations. Or do they?
Tax loss selling is discussed in the media throughout the fall and can be a good strategy to save on taxes. You can choose to apply the loss to current year's capital gains or the losses can be carried forward indefinitely. Often people heading towards retirement plan to sell a property that is not their primary residence. This is a popular time to apply a loss carried forward. Though we like to pretend it will not happen; when we die, parts of our portfolios are sold (either actually or only on paper) and the sometimes substantial gains will be taxed. Losses carried forward can pay final taxes.
One warning: You cannot repurchase shares sold for tax loss purposes until 30 days later or the loss becomes a "superficial loss". Instead of being able to claim the loss, the amount of the loss is then added to the cost base of the new shares. It is essentially just carried forward until the next sale. Though much is made of this in the media, it is only an issue if you hope to use current losses against current gains.
Did you know you can donate securities to charities instead of cash? This has to be specially arranged before you make a sale. It can be done directly through the receiving charity or through foundations. You do not pay capital gains tax on stocks with capital gains that have been donated to a charity, yet you receive a donation receipt for the full amount of the value of the security at the time of sale.
In case you are wondering why the non-registered account is in my name only, there are a couple of reasons. Having the account in my name means that any capital gains triggered will be taxed in my low income hands. I define "low income spouse". I still have unused tuition credits from when I was a student 25 years ago! One must be aware of attribution rules and where the money is coming from. We have only contributed a portion of my income to this account so far.
Charitable donations can be claimed by either spouse, so I can donate out of this account which is in my name only and my husband can still claim the donation.
I want to keep my volatile stocks in non-registered accounts so I can harvest the losses and donate the winners.
6. High-yielding Canadian dividend in non-registered (For Canadians)
A simple explanation of the Canadian Dividend Tax Credit is that when Canadians invest in Canadian corporations which pay dividends, the government allows that taxes have already been paid by the company on those dividends. Keep your higher-yielding dividend stocks in your open account to receive the Canadian Dividend Tax Credit.
Any unused dividend tax credit can be transferred from a low income spouse to a higher income spouse, so the credit earned by me in this account can still be a credit for my higher income husband.
Meanwhile, as I am growing stocks for donation, I can earn the Canadian Dividend Tax Credit on dividends earned within this account. This is effectively using dollars earmarked for donation to my benefit, so that I have more dollars to donate!
Yes, I think even plain vanilla non-registered accounts used skillfully have some excellent embedded tax advantages.
Ideal asset location of my portfolio
This is not where my portfolio is, but where I wish it to be. It is a work in progress. The next article will discuss how I am transitioning holdings and the complications and frustrations of moving towards my ideal asset location.
Last quarter, I started feeling the pinch of "closed" accounts for the first time. I am using the term "closed" here to refer to accounts that are no longer being added to, borrowing from "closed-end funds". The only way these accounts are going to grow now is internally by capital gains and dividends: no or little contributions. You cannot imagine the constraints this has caused! Or maybe you can; especially if you are in the distribution phase of your investing.
Previously, I was able and willing to simply add funds to any account depending on which holding I was looking to increase or where I wanted to initiate a holding. With fresh funds flowing into the portfolio bi-monthly there was always money to deploy virtually anywhere. Now that I am no longer adding to all of the accounts, I have run into constraints and frustration.
At the end of last year, I transferred much of the tax-free accounts into the registered retirement account in order to trigger a large tax refund again. From now on, I will be contributing very minimally to the registered retirement accounts, as I do not want to create a tax burden in retirement when required withdrawals begin. Thanks to income-splitting rules, I do not believe I have yet. In future years, contributions will build up the tax-free account until their contribution room has been reached, and then further contributions will be directed to the non-registered account, which has generally been ignored thus far.
Are the accounts currently structured the way I wish they were?
Not exactly. In hindsight, I would have contributed more equally to his retirement and the spousal retirement accounts. I was told that it did not really matter to have separate accounts because the availability of income-splitting would negate the need. Although this is true, having ample available funds in the spousal account would allow for withdrawals before age 65 in that account to be taxed in my low-income hands, as long as no contributions are made in the previous three years.
Having these accounts more even might allow us the option of postponing conversion of the retirement account to a withdrawal account. Income-splitting cannot happen before the conversion, so if we wish to take significant funds from his retirement account (if he was to retire early, for example) it would be only taxable to him and not splittable between us. We could convert early, but once a conversion is done, it cannot be undone and the income is required to be taken out, no matter what the consequences might be, or what other taxable events happened to you that year, (such as capital gains from property or securities) or whether the income is even needed.
I like to create as many future choices as possible. Had I fully understood the consequences, it would have been easy to make these accounts the same size (or tilted in my low-income favor) in order to directly manage ourselves who bears the tax burden in each individual year without constraints. I am considering the impact of withdrawing from the larger account and immediately contributing to the smaller spousal account. The main drawback to this is needlessly eating up irretrievable contribution room. From this vantage point, that does not seem to be a problem, but I am keenly aware of how quickly life situations can change.
Another thing I would not do again is transfer quite so much out of the tax-free account at the end of the year. Not keeping the tax-free as full as possible, as continuously as possible is giving up tax savings. I want them to become "closed accounts" by March or April. This year, it will not happen until September, at the earliest.
I also want to contribute more to the non-registered account to take advantage of tax loss selling, donating winners and earning the Canadian Dividend Tax Credit.
Disclosure: The author is long MCD, KO, JNJ, GIS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. I am long all stocks included in my ideal asset location chart. I am a Canadian investor. Though I have tried to include appropriate information for American investors, you should confirm exactly how these rules apply to your country and situation.