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

When TFSAs were launched in 2009, investors were thrilled with their new tax-free growth potential. However, the new account type also created another asset-location decision to wrap our heads around. We’ve already explored the impact of asset location between TFSAs vs. RRSPs, as well as between RRSPs vs. taxable accounts. That leaves one more permutation to consider: TFSAs vs. taxable accounts.

The good news is, deciding whether to hold equities in your TFSA or taxable account first seems much more straight-forward than the other asset location decisions we’ve already reviewed. So, hang in there.

A savings account that isn’t

Many Canadians have chosen to invest in their TFSA as if it were just another bank account, letting their deposits languish in cash. Others have dialed up the risk a whisker-width by investing in fixed income securities like GICs or bonds. Another subset has gone the opposite direction and filled their TFSAs with growth-oriented equities. A few have even dialed up their risk into the red zone by piling up on penny stocks. You can read about some of these lucky winners here. But remember: For every wild success story, there are undoubtedly far more unsung players who lost it all.

Blame all these random acts on whoever decided to call it a tax-free savings account, as if the holdings were to be treated as “extra” money. If I were in charge, I’d rename it to tax-free investment account, which I believe is the more appropriate way to think about it.

Where to, equities?

In the context of appropriately managing your TFSA within your overall portfolio management, let’s explore whether your equities should first go to your taxable account or your TFSA. For this, we’ll continue with similar assumptions from our past examples, holding $100,000 in each account type with a 20% tax on taxable capital gains, a 10-year measurement period, no portfolio rebalancing, etc. We’ll add one more parameter for good measure: The equities are US stocks, with a 2% gross dividend yield (the S&P 500 Index dividend yield as of June 30, 2018).

After reading our Foreign Withholding Taxes white paper, many readers assumed it was better to hold foreign equities in their taxable account rather than their TFSA, as withholding taxes were generally recoverable in taxable accounts, but unrecoverable in their TFSA. Not so fast with this logic:

• Investors pay tax on the annual dividend income in a taxable account. Assuming a 50% marginal tax rate on a 2% foreign dividend yield in a taxable account, you would lose 1% per year in taxes. This is compared to losing 0.3% in foreign withholding taxes in a TFSA account, based on a 2% dividend yield × 15% US withholding tax.
• Even if you use a swap-based US equity ETF in your taxable account, the 0.3% annual swap fee is identical to the 0.3% foreign withholding taxes levied on foreign US dividends in the TFSA.
• Unrealized capital gains in a taxable account eventually must be realized (unless you donate the shares in the future), so taxes would be payable then. Any growth in the TFSA is never taxed.

With a foreign withholding tax myth dispelled, let’s continue to explore where those equities really belong.

Option #1: Equities in the taxable account first

For Option #1, I’ve made the following assumptions:

• We hold the swap-based Horizons S&P 500 Index ETF (HXS) in the taxable account. This makes the calculations easier to follow, and the portfolio more tax-efficient.
• The taxable account’s gross return on equities is 7%. (Net return is 6.7%, after swap fees of 0.3%.)
• We hold a plain-vanilla fixed income ETF in the TFSA, with a gross return of 3%. Net return also is essentially 3%, as there are no foreign withholding taxes or swap fees.
• At the end of the 10-year holding period, the gains in the taxable account are realized, and the taxable portion (i.e. half of the gains) are taxed at 20%. The TFSA proceeds are never taxed.

The post-tax portfolio value after 10 years is $316,534.

Option #2: Equities in the TFSA account first

Now let’s switch the asset locations of the equities and fixed income to see if it makes a difference. In this example, I’ve held the equities in the TFSA account first, while the lower-yielding fixed income securities are held in the taxable account, with the following assumptions:

• The swap-based Horizons CDN Select Universe Bond ETF (HBB) is held in the taxable account (again, for tax-efficiency and easier math).
• The gross return on fixed income in the taxable account is 3% (the net return is 2.85%, after swap fees of 0.15% are levied; this is slightly less than in our first example – 2.85% vs. 3%).
• The TFSA gross total return on equities using a plain-vanilla US equity ETF is 7%. (Net return is 6.7%, after unrecoverable foreign withholding taxes of 0.3%, based on 15% of the 2% gross dividend yield.)

After 10 years, the post-tax portfolio value is $320,471, which is $3,937 more than in our first example.

Pulling it all together

Today’s comparisons indicate that the preferred tax-efficient strategy is to hold growth assets with higher expected returns in your TFSA, even if you lose a portion to foreign withholding taxes. As always, there are exceptions to this rule of thumb, but I believe it should be the default starting point for discussion.

In my next blog post, I’ll take you through specific examples on how to set up my model ETF portfolios across your various accounts, depending on which asset location path you choose to follow.