After determining the relative proportions of fixed income, equities, and cash in your portfolio (your Asset Mix), the next step is deciding which assets should be purchased in which account. In a regular taxable account, earned interest is taxed at the highest rate, followed by dividends eligible for the dividend tax credit, and lastly capital gains (which are taxed at half the rate of interest income). For this reason, owning equities in your taxable accounts is prioritized over interest-bearing fixed income.
Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) are exempt from tax on income and growth until such time that funds are withdrawn from the account. Withdrawn amounts are fully taxed as regular income. Interest-bearing fixed income investments tend to be preferred in these accounts, especially when withdrawals are expected within a few years. The same taxation rules apply to Locked-In Retirement Accounts (LIRAs) and Life Income Funds (LIFs).
Tax-Free Savings Accounts (TFSAs) are exempt from all taxation, whether on income, growth, or withdrawals. Using a TFSA to hold your highest-taxed investments, such as interest-bearing GICs and bonds, may seem like the logical choice, but other considerations may weigh more heavily than the immediate tax costs. TFSAs tend to be held for a long time, and in many people’s retirement plans they represent the last account from which withdrawals are made. The long time-horizon makes TFSAs more suitable for holding equities, which typically earn greater returns than fixed income over long periods. The higher returns could generate more tax savings in a TFSA despite the favourable tax treatment of capital gains. Importantly, higher returns will inflate the TFSA more than if it was invested in modestly-returning fixed income, and a larger tax-free account is unambiguously superior to a smaller one. We tend to invest TFSAs in keeping with the overall portfolio’s asset mix, including both equities for growth and fixed income for stability.
When it comes to equity investing, eligible Canadian-source dividends qualify for the dividend tax credit. Dividends from foreign countries are fully taxed and may be subject to foreign withholding tax, which is usually recoverable in taxable accounts. Foreign withholding is not always recoverable, however, such as in TFSAs. For a full picture of how the source of income can affect your taxes, see our article on Tax-efficient asset location.