This page examines another aspect of investing that is fortunately optional because it requires mental gymnastics: asset location or tax optimization. It should probably be avoided by most DIY investors and that is the blanket advice given around the internet. Some think the information about asset location strategies and tax optimization is dangerous and should be locked up. However, most DIY investors do not face the same tax burden as high-income professionals. Nor do they use more complex investment vehicles, like a professional corporation.
Most high-income investors recognize this and have taxes top-of-mind. Understandable, since taxes are often the largest line item in their budget. Unfortunately, that may paralyze them from DIY investing because they feel that they are missing something important. The promise of tax optimization may also steer them to pay a professional to do it for them or towards complex products that may save on tax but lose that to higher fees and decreased flexibility. So, we should learn a bit about asset location and tax optimization to make an informed decision. That could be to attempt it in a manner that you can reliably execute, or to purposefully ignore it.
In The Wrong Spot?
What is asset location or tax optimization?
We buy different investments to suit our risk. The mix of investments (like stocks:bonds) is our asset allocation. We need to hold those investments in different account types (like TFSA, RRSP, or Corp) that all have different tax characteristics. Different investments produce different types of income (like interest, foreign dividends, or eligible dividend) with different tax characteristics.
Matching investments to their most tax efficient account location is called asset location.
Tax optimization sounds like a no-brainer good idea. You can’t predict markets, but fees and taxes are pretty predictable. However, the advice to ignore asset location is generally good advice due to the practical difficulties people have in actually doing it. That is the crux of the dilemma, and we can start exploring it by looking at how simple asset location is to ignore.
Ignoring asset location is simple & transparent.
Simple to execute.
Asset location is easily ignored by simply buying the same investments in each account. For example, if I decide that a 50:50 stocks:bonds asset allocation suits me, then I put that in all my accounts. No need to guess what future tax rates will be or what progressive income tax brackets I will be in. There is also no figuring out tax drag differences between accounts. Simple and easy to execute.
Transparent: the after-tax result is the same as what was intended.
We see the pre-tax value of our accounts all of the time just by looking at our investment statements. However, we can only spend money after the tax liabilities have been paid. For example, to spend money from an RRSP, the money taken out is taxed fully as income. To spend money from my TFSA, there would be no tax owing. If I hold safer assets (like bonds) in my RRSP and risky equities in my TFSA, then by the time I get money into my hands, I really had less allocation to bonds than I thought I did after the tax from taking them out of the RRSP is paid. In contrast, by ignoring asset location, the risk I was taking pre-tax or post-tax is identical.
The Balance: Potential Tax Savings vs Execution Risk
Execution risk is the risk of not being able to stick to a disciplined robotic investment plan. Complicated often translates into procrastination (until you have the time to do it right) or an unintended error (because it is complicated). On the other hand, that risk needs to be weighed against the potential benefit. It is a balance between execution risk and tax reduction. That favors simplicity for the average DIY investor starting out – they need simple to execute and the potential benefit is marginal.
The Priority of Asset Location in the Investing Process
The reason why asset location is optional and usually ignored is because the potential impact on returns is much lower than other parts of the investing process. Further, it could hamper execution of your plan, which is vital.
The most important aspect of investing is to actually invest. Put money into the markets over a long period of time to benefit from compounding returns. Depending on the asset allocation, markets have returned in 6-10%/yr range over the long run.
Investor behavior is the next most influential aspect of investing. The behavioral gap averages between a 0-2%/yr drag on returns due to buying and selling in a non-mechanical fashion. It can be much worse if you panic sell at a bottom. Getting the right asset allocation for your risk tolerance helps, as does a simple mechanical plan. An advisor may also help by “talking you off of the ledge” in a down market.
Advisor fees are the next biggest potential drag on performance. Whether an advisor has a net benefit or drag is a balance between the fees charged and whether the advisor helps you to set goals, save/invest, implement, and stick to the plan better than you can on your own. Hence, the importance of simplicity for DIY. Further, this is why the low-fee, simple, and effective approach of using all-in-one asset allocation ETFs is the usual go-to method.
In comparison, the impact of tax optimization is very small and the complexity to execute likely nullifies it for the average DIY investor. For an investor with a high-income and large portfolio, particularly if incorporated, there may be more benefit to asset location tax optimization. With a corporation the tax drag of investments is complicated and changes during accumulation and drawdown.
When the balance favors ignoring asset location.
When your tax burden is low, there is very little to gain.
For example, if only using a TFSA and RRSP, and a taxable account in a moderate current tax bracket (~$90K income) and $45-$75K income at retirement – the potential savings are <0.1%/yr. Even at the highest marginal rate, the savings would be ~0.3%/yr. That assumes optimal conditions without having to sell (and pay capital gains tax) to rebalance.
Small contributions/withdrawals & a large portfolio, the savings are blunted.
Reality is not optimal. The markets don’t smoothly increase by the same % every year. Rather, different markets actually fluctuate in a correlated, but independent, fashion. That may hamper the effect of asset location in practice due to capital gains tax costs from rebalancing if asset classes swing radically differently from each other.
When these semi-random returns are accounted, the potential savings drops to an average of 0.08%/yr and better than ignoring location 74% of the time. That is from 1000 Monte Carlo simulations done in this 2017 white paper by Ben Felix for a static portfolio (no contributions) and average tax bracket. At the highest marginal tax rate, the value-add of tax optimization averaged 0.23%/yr and won 80% of the time.
The deleterious effect of random returns may not be as bad in real-life if you are making large contributions or withdrawals relative to the portfolio size. In that circumstance, you could rebalance by buying what is low during accumulation or what is high during decumulation.
If you can’t, or shouldn’t, trick yourself using pre-tax asset location optimization.
Much of the benefit of pre-tax asset location results from putting bonds in the RRSP. That allows us to share the low expected return of bonds with the government while still benefiting from the stabilizing effect they have when we look at our investment account statements. That is because we get a tax refund while contributing (pre-tax investment) and pay regular income tax when we take the money out. For example, if you will eventually take money out of your RRSP in the 50% tax bracket, then the government shares 50% of your investment return.
When the tax liability embedded in the RRSP is accounted for, much of the benefit of pre-tax asset location is due to tricking yourself into taking more post-tax risk. This is illustrated in the diagram below and Ben Felix wrote a 2019 white paper describing it.
Hiding the volatility to stomach more risk and potential return could be helpful if your behavioral risk is the main thing holding you back from aggressive investments and you have a large risk capacity. However, if you automatically start discounting the value of your RRSP or Corp when you look at the statement, then you are unlikely to trick your emotional investor beast. Further, if you will need that money in the near future and don’t have flexibility if you get an unlucky sequence of returns then after-tax allocation is vital to manage that risk.
You could use a post-tax asset location strategy if you can’t or shouldn’t hide the volatility risk. That could improve the post-tax efficiency by ~0.1%/yr for a static portfolio of a TFSA, RRSP, and personal taxable account. However, it also increases the complexity because you must estimate future tax rates.
If you are not able to do it simply and reliably.
By its nature, asset location requires to you to use multiple ETFs. So, you must be comfortable buying and selling them. That is actually very simple. However, many people starting to DIY invest find that intimidating until they have done it a few times. To optimize further, you may also want to use US-listed ETFs which requires comfort converting currencies using Norbert’s Gambit or accepting a currency exchange fee. Again, simple once you have done it a few times, but intimidating to someone starting out.
The math is not simple for operationalizing an asset location strategy. You need to redo the calculation with each rebalancing. There are a number of considerations and assumptions to make. If you can’t do that quickly and easily, then it will cause you to delay investing or make errors. These could easily cost more in performance than the potential gain for most people. Hence, the general advice to ignore it.
To help combat this problem, I have made portfolio building tools that automate the math. However, to use them, you need to have some basic understanding of how asset location optimization works. More on that later with a deep dive into asset location strategies and assumptions.
Who May Want To Learn More & Consider Asset Location
If you are in a high tax bracket and comfortable with the basics of investing, then it may be worthwhile to learn more about asset location. This is particularly relevant for those with a corporation. A corporation can be extremely tax efficient or extremely inefficient depending on multiple factors. Unfortunately, corporate taxation is also complex and the efficiency changes as it grows and you spending changes. Fortunately, most of those inefficiencies don’t arise until the corporate portfolio is getting over $2-3MM and/or you are an extreme high-earner-low-spender. So, obsessing about tax optimization should not deter you from getting started. Plus, it is less daunting when you are experienced with the basics of DIY investing.
For those for whom it may be appropriate, there are multiple ways to approach tax-optimized asset location and operationalize it. For those who want to learn more, I have created three more pages to explore the considerations that make asset location complex (and potential solutions), the potential benefit in different scenarios using a corporation, and some portfolio building tools that I have created to help automate the math.