≡ Menu

Determining a Master Portfolio Allocation:

Master Portfolio Allocation

A reader by the name of Doug writes,

“…I’m struggling with a portfolio problem and could really benefit from some discussion. My wife and I are both 32 with good stable incomes. We are in a position to max out our RSPs every year and still have quite a bit leftover for TFSAs, and a non-registered account. I’m trying to determine a master asset allocation across all the accounts. Some of the things I’m struggling with:

  • What kind of equity weighting should I have in RSPs since capital losses cannot be harvested
  • Fixed income in the non-registered account (tax treatment is unfavourable but I’m only moderately bullish on global equity markets over long term).

I guess I’m looking for some general principles about an integrated asset allocation across all these accounts. Any resources you could point me to would be appreciated.”

This is a dominant theme in recent emails or private conversations with investing peers and clients. With the recent decline in markets and investors recognizing the effect of fees on returns there are more and more individuals interested in accepting their own responsibility for managing their investments.

Asset allocation can be a daunting task and intimidating struggle when you try to put everything together to create a long-term investing plan. What helps a lot of the time is taking a moment to breakdown the pros & cons of various investing accounts (TFSA, RSP & non-Registered) to compare what types of investments fit best where and why.

There is no cookie cutter way of creating a retirement plan for all. Goals and objectives need to be addressed on an individual basis and are obviously dependent on available finances. If an investor or couple doesn’t have adequate savings each month to put towards a master portfolio allocation including all three options (TFSA, RSP & non-Registered) than a passive approach to of investing in index mutual funds in only one or two accounts would be the better alternative.

The Tax Free Savings Account (TFSA) is a new account introduced by the Federal Government of Canada as an incentive for individuals to grow the interest, income and capital gains from investments tax free with the additional availability of withdrawing those gains without taxation. There is no tax rebate offered as with a registered savings plan (RSP) but for many individuals who max out their contributions to RSP’s each year a TFSA offers an excellent opportunity to build a secondary portfolio for retirement. Some individuals will use it simply as a short-term savings account, but with $5,000 of contribution room per year indexed to inflation the TFSA over the course of 5-10 years could create significant tax-free growth on savings.

One of the most important investing rules is to understand what you own. In the stock selection process I advocate that investors understand as much as they can about their investments (stocks, bonds, GIC’s, mutual funds) and something that isn’t discussed often enough and equally as important is the concept of understanding where to own your investments.

Individual investments are treated very differently depending on what investment account you hold them in: RSP, TFSA or non-Registered. Taxation of investment income, capital gains and access to your investments are very important factors to consider before you ever make an investment or place an investment in any of these accounts. When an investment advisor recommends to place an investment into one account over another because of one advantage doesn’t mean that it fits your needs over an alternative; you should consider the whole picture. Each investor should have the foresight to anticipate the impact of placing an investment in specific investing vehicles.

Here are some main principles I stick to with regards to each account.

Registered Savings Plan (RSP):

  • Contributions eligible for tax rebate at your marginal tax rate
  • All gains compound on a tax deferred basis
  • Exempt from US withholding tax on dividends paid by US corporations
  • 2009 individual contribution limit is 18% of annual income, but no more than $21,000
  • Canadian paid dividends not eligible for dividend tax credit
  • Must be converted to RRIF (registered retirement income fund) at age 71

Tax Free Savings Account (TFSA):

  • Contributions not eligible for tax rebate
  • All gains compound tax free
  • Withholding tax on income paid as dividends from US corporations has not been indicated yet by the CRA on eligibility to exemption
  • 2009 individual contribution limit is $5,000 regardless of income
  • Canadian paid dividends not eligible for dividend tax credit
  • No conversion necessary at any age

Non-Registered Account:

  • Contributions not eligible for tax rebate
  • All realized investment gains taxed directly at varying tax rates
  • 15% of income paid in dividends from US corporations withheld
  • No contribution limit
  • Canadian dividends eligible for dividend tax credit
  • No conversion necessary at any age

My Considerations:

The difficult part of any master portfolio allocation is to consider your individual situation.

RSP:

I have a DBP pension (defined benefit plan) which at retirement will pay out a specific amount of income when I retire. I want to take advantage of the availability of contribution room in my RSP for the obvious tax benefits, but I need to be careful that I don’t accumulate a significant portfolio within my RSP by the age of 71. The reason for this is simple: at age 71 I am forced to convert my RSP to a RRIF and there are mandatory withdrawal rates on the RRIF that the government forces you to take regardless of if you need the income or not.

Assume for the moment that I aggressively placed all my savings in my RSP from now until retirement. Starting with $10,000 at age 28 and by contributing a minimum of $18,000 per year to my RSP grown at a 5% return my RSP at age 70 would be just shy of $1.5M. Now that sounds like a phenomenal achievement and the tax deferred growth of the portfolio is impressive, but that tax deferred growth is still only tax deferred.

Starting at age 71 the government, based on current percentages, would force me to withdraw 7.38% of the outstanding balance; $110,700. Add in my pension and my taxable income could be over $150,000 per year. The frustrating part in the situation is that I have no choice, no flexibility and my marginal tax rate (MTR) would be over 46%! If you think you’ll be feeling charitable by retirement and enjoy paying the government nearly half your income each year then the situation is great, but 46% is a lot higher than I ever intend to pay.

TFSA:

The benefit of a TFSA is that I can grow my investment gains tax free, withdraw any amount without taxation and I do lose the tax refund versus a RSP since I’m only contributing after-tax dollars. Let’s assume that I start my TFSA this year (2009) with $5,000 and only contribute $5,000 each year growing at 5% for the same time period (until age 70). The size if my portfolio at age 70 would be $750,000 but I would have the complete flexibility of withdrawing as little or as much as I want depending on my needs, exposure to taxation and other considerations. When paired with a DBP pension this would be an optimal solution for my retirement needs.

Non-Registered:

A non-registered portfolio gives an investor the most flexibility because you can contribute any amount and withdraw any amount but your returns are eroded the most because of your exposure to taxation. Income from interest is taxed at 100% of your MTR and capital gains at 50% of your MTR. Only Canadian dividends offer some relief, but if your income is over a certain amount (greater than $40,650 in Ontario for 2009) you still pay taxes; although significantly lower than gains from interest income.

Situations:

Creating a master portfolio allocation, as mentioned before, will depend entirely on the individual situation of the investor. What I strive to teach is that an investor not focus completely on the total return of today, but the flexibility of returns in income, growth and withdrawal over the long term.

If an investor (or their spouse) doesn’t have a pension than it is more than reasonable for an investor to fully commit the majority of their savings to their RSP (or spousal RSP) in order to create their own pension at retirement. You’ll pay higher taxes post RRIF conversion, but have a large enough nest egg to compliment any government assistance that you receive.

If an investor has a pension then you want to take into consideration how large your RSP may be at age 71 when you are required to convert to a RRIF. The TFSA and a non-registered portfolio can grow over time to provide additional income and flexibility so that you have more than one source of income that you can retrieve funds from while minimizing your taxation.

My Situation:

Because I’m young, 28, and contributing to a pension I am consciously aware that I don’t want my RSP to be massive prior to its conversion to a RRIF, but I do want to take advantage of the tax refunds I can receive today and in the future. I do contribute about 50% of my eligible RSP contributions each year because in future years my income will be higher and compounding growth will have a lesser effect. Optimally in the future my RSP contributions will increase, but only after I’ve taken the time and money to construct a dividend growth portfolio that can grow over the next 30 years without interruptions.

I keep all my fixed income in my RSP for two reasons:

  1. All income from interest is tax deferred
  2. Historically fixed income grows slower than equities

This way I save on the highly taxable characteristics of interest income and the compounding effect within my RSP is kept at a more conservative pace than if I kept my RSP heavily invested in equities at 70% or greater.

I keep all my US and International equities in my RSP for two reasons:

  1. All dividends or income are exempt from withholding tax from US corporations and the majority of foreign corporations
  2. These are long-term investments that I don’t intend to sell so they provide growth to compliment my fixed income component

I keep all my Canadian dividend paying equities in my non-registered account:

  1. Maximize the eligibility of the Canadian dividend tax credit
  2. I am constructing a portfolio of tax efficient income that will grow over time
  3. This is my main retirement portfolio that I intend to retire with

For my TFSA I’ve currently placed my initial $5,000 in a set of TD index E-funds and cash for a passive investment strategy. After 4-5 years I’ll likely use this to invest in combination with my non-registered account for Canadian dividend paying stocks as my income will be higher and the dividend tax credit not as attractive as it currently is at my MTR.

For an investor you want to create a picture of what you first want your retirement to look like and you can then ask yourself what your portfolio should look like at retirement and work backwards. Consider the effects of current and future taxation on your pension, investments and combined household income. Spousal RSP’s for individuals with an existing pension are an underutilized strategy for investors looking to save on current taxation and create a retirement investment for their spouse.

For myself at retirement I would be quite comfortable with the following portfolio breakdown at age 70 assuming I retired in my early 50’s with a small DBP pension.

RSP: $325,000
Non-Reg: $650,000 or higher
TFSA: $350,000

To answer Doug’s questions directly,

The equity weighting you should have in your RSP will reflect the type of growth you want to achieve in that account. If you’re content with earning 4-6% annually then place all your long-term fixed income (bonds) in your RSP with short-term fixed income outside your RSP and carry an equity percentage below 50% (70/30 or 60/40 weighted towards bonds). You’re 32 with the potential of over 30 years until retirement. Equities have historically outperformed fixed income in terms of growth so don’t exclude equities completely from your RSP because of the power of compounding returns that will be tax deferred. Over the long-term your short-term capital losses should turn into gains especially if you’re invested in equity ETF’s versus individual stocks.

Click here to see how future posts can be delivered directly to you

Subscribe to The Stock Analysis Mailing List

Email Format

{ 7 comments… add one }
  • T.F. Savings April 15, 2009, 2:53 am

    Thanks for another insightful addition. Your Q & A section is very valuable because the writing is easy to follow and your readers always seem to use very relatible examples. More people need to know about how to properly use a Tax Free Savings Account which means more people should be reading it here! Keep up the great service to your readers.

  • Anonymous April 19, 2009, 1:54 pm

    I’ve read 100’s of blog postings but this is the first one I have ever commented on. Great post!

  • Nurseb911 April 19, 2009, 2:04 pm

    Thanks TF & Anon,

    Anon: Congrats on making your first comment. In the future if there's a topic you'd like to have discussed be sure to let me know.

  • Anonymous June 10, 2009, 6:51 am

    Very informative, thank you.

  • Anonymous August 18, 2009, 9:32 pm

    Hi, how do i open a td efund TFSA account? I ccan't find information on td website.

    Thanks!

  • Nurseb911 August 18, 2009, 9:48 pm

    The TD e-funds can be purchased through any TDW account. If you open a TFSA at TD Waterhouse you can purchase the e-series funds directly through there as well as any stocks, bonds, mutual funds or GIC's you want. Make sure to sign up for the eServices though so there are no annual fees.

  • Think Dividends December 4, 2009, 2:18 pm

    Great article Brad.

    Question: Are your International Stocks (ADRs) exempt from withholding tax since you hold them in your RSP? I am wondering if it makes sense for me to move Diageo (NYSE:DEO) into my RSP.

    Thanks

Leave a Comment