An Example of Allocating Holdings to Minimize Taxation

As a follow-up to yesterday's post on taxation of different income types, I want to go through an example so that you can see how one might think about where (RRSP, TFSA or taxable accounts) to hold different funds in your portfolio.

Let's consider what happens if you decide on an asset allocation of 25% each in the following types of index funds:

• Bonds
• Canadian Equities
• US Equities
• EAFE Equities

Let's also say that you have RRSP room for 50% of your portfolio, and the other 50% will have to go into your taxable account. Where would you put each of your funds? Let's look at the general income characteristics for each of these funds. Again, I am thinking in terms of index funds. Actively managed funds will have different tax profiles.

Bonds count as interest income and are fully taxed at your marginal rate.

Canadian Equities, when in an index fund, generally produce dividends and small capital gains. (In an actively managed fund, expect higher realized capital gains for which the tax liability is passed on to you.)

Similarly, the US Equity fund also generates dividends and some small capital gains, but these are considered to be from foreign sources.

Finally, the EAFE (roughly the rest of the developed world) Equity fund, since it covers a (generally) more volatile index, will probably generate more capital gains, as well as some dividend income. As with the US Equity fund, this income is considered to come from foreign sources.

In my opinion, and I'm no tax specialist, I would definitely put the Bond fund into the RRSP since its interest income would otherwise be taxed at your full marginal rate. The Canadian Equity fund would go into the taxable account to take advantage of the reduced tax rates on Canadian dividends and capital gains.

It's a bit of a toss-up between the US Equity fund and the EAFE fund, but I would put the US Equity fund into the taxable account and the EAFE fund into the RRSP since I believe that the US Equity fund will trade less and therefore generate fewer realized capital gains tax liabilities.

RRSP: Bond fund, EAFE fund
Taxable account: Canadian Equity fund, US Equity fund

Strategically allocating your holdings in your taxable and tax-sheltered accounts will help ensure that no matter what earnings you make, you actually keep the highest percentage for yourself as possible.