You’re familiar with the memorable real estate phrase ‘location, location, location.’ A similar approach applies to the collection of investments you own.
Investors need to understand which accounts are better suited to hold their investments. Three pools of capital suffice.
Don’t just sprinkle investments you buy into any random account on hand. Instead, I recommend an organization that has purpose for your investments.
It is part of income tax planning and is called “asset location”. That is, selecting investment accounts best suited to hold specific assets owned.
Overall, asset location is an integral component that fits like a glove with your asset mix.
You will make plenty of decisions, like the RRSP or TFSA, will involve asset location. Unfortunately, my observation is that asset location barely registers on the investor radar.
The good news is that rejigging a few steps delivers much more value. Here is my simple approach:
- Relate asset location decisions to the types of investment income you expect.
- Investments produce combinations of interest, rental, dividend, gain and loss income.
- One objective of the location combination you choose is to pay the least income tax.
- Using three different investing pools provides plenty of flexibility.
I refer to the blend of taxable, tax-deferred and tax-exempt investing accounts. These three pools of capital implement your asset location strategy:
They are mainly cash and margin accounts owned personally, by a company or a trust. Equity investments, such as stocks and ETFs, are best held in these accounts for tax efficiency. Canadian dividends, gains and losses received in these accounts are better taxed than interest. However, the account owner reports the taxable income every year as deferral is not available. Note that real estate property generates “depreciation expense” which reduces taxable income. Lastly, income earned on investments owned by the low tax rate spouse attracts less tax.
Tax-deferred accounts include the RRSP, RRIF, IPP, DPSP, LIF, LIRA and other locked-in plans. Investment income earned in these accounts is tax-deferred until withdrawn. Where possible, interest bearing investments are more suited for such accounts. All funds withdrawn from tax-deferred accounts are fully taxable, like salary. There is no preferential tax treatment of Canadian dividends, capital gains or losses. Further, the dividend tax credit is lost as it cannot be used within these accounts.
A TFSA is desirable as both the capital and investment earnings are tax-exempt on withdrawal. Contributions are not deductible, but each spouse can arrange the annual maximum deposit. It makes sense to hold investments with capital gain potential in the TFSA. Dividend tax credits are lost in TFSAs and capital losses don’t offset gains outside TFSAs. Unlike RRSP deposits that stop at age 71, TFSA deposits can be made for your lifetime. Redirecting part or all of the RRIF/LIF payments can help fund annual TFSA deposits.
Locating specific investments in all three pools provides maximum flexibility in retirement. However, not every family may have sufficient savings to allocate among all three choices.
For example, funding RRSP accounts can become priority during high income years. Switching to a TFSA is more sensible during lower income years.
Decisions to draw retirement funds from all three pools can change every year. You may need to explore the implications of RRIF/LIF minimums.
Investor access to the three pools also provides more options for consideration. One key implication is when to start receiving CPP/OAS family benefits.
Overall, asset location is an integral component that fits like a glove with your asset mix. It’s best to weave both strategies into your game plan at the same time.
Ensure that all location choices are considered for your best interests. Your combination of asset location and asset mix may need a rejig to reach family goals.