Asset Location in a Post-Tax World: RRSPs vs. Taxable Accounts

In my last blog post, we determined that the overall post-tax asset allocations in your TFSA and RRSP have a far greater influence on your post-tax portfolio value than the asset location of these various asset classes within your portfolio. In other words, it’s the kinds of investments rather than where you hold them that seems to matter the most between these two venues. I also offered nine different asset location strategies to consider, depending on your investment preferences and circumstances.

Once you’ve maxed out available room in your TFSA and RRSP, you and your money enter the taxable investing universe, where the logistics become even more cosmically confusing.

One of the most common questions I receive from investors is whether it’s more tax-friendly to hold equities in their RRSP or taxable accounts first. Just when you thought you were getting the hang of things! In this comparison, I’m about to demonstrate that your post-tax asset allocation and asset location both determine your post-tax portfolio value in approximately equal measure – unlike in our TFSA vs. RRSP scenarios.

I’m afraid this concept is also trickier to illustrate. Hang on tight, as I’ve tried to keep the discussion as simple as possible (but not simpler). In the examples that follow, we’ve once again assumed annualized equity returns of 7% and fixed income returns of 3%. At the end of the 10-year period, the full RRSP value is taxed at 20%, while half of the capital gains in the taxable account (i.e., the taxable half) are also taxed at 20%. The portfolios are never rebalanced during the measurement period. Annual rebalancing would certainly impact the ending portfolio values, but not the main concepts.

I’ve also assumed all growth from equities and fixed income in the taxable accounts represent unrealized capital gains. This may seem like a bit of a stretch, but it’s similar to holding a swap-based equity or bond ETF in your taxable account, such as the Horizons CDN Select Universe Bond ETF (HBB) or the Horizons S&P/TSX 60 Index ETF (HXT). It also will make the examples a little easier to follow for those who prefer to break out their financial calculators.

Option #1: Equities in the taxable account first (ignoring post-tax asset allocation)

Pre-tax asset allocation: 50% equities / 50% fixed income

Traditional asset location advice is to hold equities in your taxable accounts first instead of your RRSP. The justification goes something like this: A large portion of equity returns are capital gains (which are taxed at half the rate of most other types of investment income), so it is better to hold them in your taxable accounts first. (We presume that holding equities in your RRSP will make all gains fully taxable as income when the funds are ultimately withdrawn from the account.)

If we ignore post-tax asset allocation, and purchase $100,000 of equities in our taxable account and $100,000 of fixed income in our RRSP (a 50% equity / 50% fixed income pre-tax asset allocation), we would end up with $294,557 post-tax at the end of the 10-year period.

Option #2: Equities in the RRSP first (ignoring post-tax asset allocation)

Pre-tax asset allocation: 50% equities / 50% fixed income

If we instead held $100,000 of equities in the RRSP and $100,000 of fixed income in the taxable account, we would end up with a post-tax portfolio value of $288,325 at the end of the 10-year period, or $6,232 less than in Option #1. It would at first appear that the traditional advice is correct.

But, as we discovered in my last blog post, although the pre-tax asset allocations are the same in both examples, the post-tax asset allocations are very different. In Option #1, the investor is taking more equity risk from a post-tax perspective than the investor in Option #2 (55.56% vs. 44.44%). Here’s why: Only $80,000 of the RRSP value is really theirs; the remaining $20,000 ends up owed to the government.

To really determine whether asset location decisions matter when comparing taxable accounts to RRSPs, we need to keep the post-tax asset allocation constant. We’ll do that in our next set of examples, targeting a post-tax asset allocation of 50% equities and 50% fixed income for all three, and adjusting only the asset class locations.

Option #3 (a): Equities in the taxable account first

Post-tax asset allocation: 50% equities / 50% fixed income

In this scenario, we’ll take the traditional approach of holding equities in the taxable account first, like we did in Option #1. This gives us a pre-tax asset allocation of 45% equities and 55% fixed income, which is more conservative than the 50/50 post-tax asset mix. After 10 years, the post-tax portfolio value is $288,948.

Option #3 (b): Equities in the RRSP first

Post-tax asset allocation: 50% equities / 50% fixed income

What if we keep the post-tax asset allocation at 50/50, but first hold equities in the RRSP? At 55% vs. 45% pre-tax equities, our pre-tax asset allocation is more heavily weighted towards equities than in Option #3 (a), so this asset location decision could prove to be more challenging during a market downturn. However, the ending post-tax portfolio value after 10 years is $293,934, or $4,986 more than in Option #3 (a)).

The decision to hold equities in an RRSP first (while holding the post-tax asset allocation constant) allows the investor-owned portion of the RRSP to grow tax-free (not tax-deferred), at 7% instead of 3%, like in Option #3 (a). Holding equities with their higher expected returns in the RRSP allowed the $80,000 post-tax portion of the RRSP account to grow tax-free at 7%.

Option #3 (c): Same asset allocation across both accounts

Pre- and post-tax asset allocation: 50% equities / 50% fixed income

In this scenario, we’ll hold a pre- and post-tax asset allocation of 50/50 across both accounts. It’s no surprise that the ending post-tax portfolio value of $291,441 is somewhere between the last two outcomes.

I’ve summarized the results in the table below:

So, once again, what would you like to do with your own portfolio? It turns out, my recommendations are similar to those from my last post.

1. If you want to keep it super simple, Option #3 (c) is your easiest bet. Just hold the same asset mix across all accounts.
2. For the modestly risk-tolerant investor who doesn’t mind a little extra lifting, keep following the age-old advice in Option #1 and hold the equities in your taxable account first. This presumes you can ignore the fact that you’re actually taking on more equity risk, albeit in a relatively oblivious way.
3. If you believe the only right way to go is all the way, then you might prefer Option #3 (b), where you’re tightly managing your asset allocation and maxing out expected returns. Alas, many people may not grasp your attention to detail, but you might find some appreciative fans out on Reddit.