Financial Basics 9 - Which Fund in Which Account?

This post is about which funds you should put into each of your different types of accounts (RRSP, TFSA or Taxable)

Which fund to put into which account? This is about taxes, so if you read further on in this post and think you are missing something, you should go back and read Financial Basics 2 - Income Tax to review how different types of income are taxed and Financial Basics 3 - How Different Savings Accounts Work to review how income in the different types of accounts are taxed. 


Here's a brief summary of what we need to know from those posts:

RRSP

• All interest income, dividends and capital gains are not taxed when received in this account, but
• All withdrawals from this account are taxed as income (at full tax rates).

TFSA

• All interest income, dividends and capital gains are not taxed when received in this account.
• All withdrawals from this account are NOT taxed as income.
• However, foreign income in funds within the TFSA are still subject to foreign withholding taxes (about 15%).

Taxable

• No tax deferral in this account, but it is important to understand how the different types of income are taxed.
• Interest income (income from Bond funds and income from foreign funds) are fully taxed. You do get a credit on your taxes for foreign taxes already paid on foreign funds.
• Dividends from Canadian sources are taxed at much lower rates.  If your income is below about $50,000 the marginal tax rate on dividends is about 0.  If you are in the top federal tax bracket, with income above $140,000, then the marginal tax rate on dividends will be about 1/2 to 2/3 of the marginal tax rate on income. 
• Capital gains are not taxed until you sell a fund. The great part of this is the gains can keep building until you need the money in retirement, then you pay the taxes on the gains and also likely at a lower tax rate in retirement than during employment. The current inclusion rate for capital gains is 50% so capital gains will be taxed at 50% of the marginal tax rate of income. 

In Post #7 I made a short statement about which ETF fund should be in which type of savings account (RRSP, TFSA or Taxable). The guideline is to put the one(s) with the highest tax payable from income each year into the tax advantaged accounts. This will defer as much tax until your retirement and allow you to keep as much money as possible so it can grow in your accounts. The asset classes sorted by highest to lowest taxable income is Bond, International, US and then Canadian. 

How did I arrive at that?

The table below shows the 4 asset classes we are investing in.  For each class I have listed the typical yield. If you inspect the yields for an asset class in the list of ETFs in Post #8 you will see that the yields within a class are very similar. Why is this? It is because all these funds in the same class are tracking the same (or similar) indices which contain roughly the same basket of stocks (or bonds). 

Remember that the yield is the interest or dividend income paid by all the assets in the ETF. Total return of an ETF will typically be higher than the yield and the difference is capital gain, which is only taxed when you sell the ETF so it is ignored in this exercise. Of course if the total return for an ETF is less than the yield, then there will be an unrealized capital loss.

The type of yield varies between asset class. For Bond and non-Canadian funds the interest is treated as income and is subject to full marginal income tax rates. Yield from the Canadian asset class is almost always Canadian eligible dividends which receives favourable tax treatment. Last time I checked XIU income was 99% eligible dividends and 1% interest income.  

	Class	Typical	Yield	Type of	% Tax in	% Tax in	% Tax in
		Fund	(%)	Yield	Taxable	TFSA	RRSP
	Bond	XBB	3.0	Interest Income	1.20	0.00	0.00
	Canadian	XIU	2.5	Canadian Dividend	0.50	0.00	0.00
	US	XSP	1.5	Income	0.60	0.23	0.00
	International	XIN	2.5	Income	1.00	0.38	0.00

The last 3 columns express how much tax will be paid by a typical fund in these asset classes in the different account types. I assumed a 40% marginal tax rate on regular income, a 20% marginal tax rate on dividends and a 15% foreign withholding tax. I have expressed these values as a percentage of the total asset value in your account (same basis as Yield %). For example the 1.2% for Bond in a taxable account means that if you have $100,000 of Bond ETF in your taxable account, it will pay you $3,000 of interest income on which you will pay about $1,200 of income tax. By expressing it this way you can directly compare the amount payable as tax per asset class and per account type and determine which account is best to contain each asset class.  

You will note that the foreign fund classes actually pay some tax in the TFSA, this is due to foreign income withholding taxes.  In the 'More Complicated Stuff' section in Post #8, I provided a reference on this topic that explains it much better than I can. 

Moving a Bond from the Taxable account to either an RRSP or TFSA account saves 1.2% on tax. That's the biggest difference, so tax protecting Bond interest income is priority #1. The second biggest difference is to move International funds from Taxable to RRSP and the third biggest difference is moving International to TFSA, so make these your priority #2. Moving either of the Canadian or the US fund from Taxable to RRSP/TFSA results in a pretty similar saving, so I wouldn't fuss which one is priority #3 or #4. 

Let's consider an example of determining which ETF to put into which account type. Let's assume you save $14,400 each year into your RRSP, $5500 into your TFSA and $3000 into your Taxable account.  The percentages of your portfolio in your different accounts is as per the following table: 

	Account	Contribution	Percent
		($/yr)	of Total
	RRSP	14400	63%
	TFSA	5500	24%
	Taxable	3000	13%
	TOTAL	22900	100%

Consider the Portfolio I recommended in the previous post:

	Class	Portfolio
		(%)
	Bond	25
	Canadian	30
	US	30
	International	15
	TOTAL	100

The funds would then be placed in the accounts as per the following table.  Note that there is enough room in the RRSP to shelter all the Bond, all the International and some of the US.  The remainder of the US and some of the Canadian are in the TFSA and the remainder of the Canadian, which will be 99% dividend income, in the Taxable account.  

	Class	Portfolio		Account (%)
		(%)	RRSP	TFSA	Taxable
	Bond	25	25
	Canadian	30		17	13
	US	30	23	7
	International	15	15
	TOTAL	100	63.0	24.0	13.0

I have created a Portfolio Live Spreadsheet that will do the above calculation for you. Please see the post regarding the spreadsheet for more information.

That was a pretty heavy post, but since it has to do with taxes, it's really important!


Disclaimer:  These posts are not fully comprehensive financial advice.  You should seek your own qualified investment, tax and legal advice.