Tax optimized asset location is an optional part of the investing process. It is probably best ignored for the average DIY investor. That is because it is complex and increases the risk of not executing the plan properly in the hope of a small potential benefit. For those facing a large tax burden, the benefit of tax optimization is larger. However, the actual implementation process requires a number of trade-offs and assumptions.
The complexity of execution can be partially addressed by making the process easier, like using my Robocorp portfolio building tools. However, whether it is worth the hassle or not is still a question to consider. The largest potential benefit for tax optimization is for those with multiple accounts, including a professional corporation. This page explores the potential benefits of asset location involving a corporation.
In The Wrong Spot?
Does the corporation become inefficient early or late career?
The tax efficiency of a corporation during accumulation is variable. The interplay of corporate income, personal income, and personal spending on the combined personal and corporate tax efficiency changes over a career. The corporation becomes less efficient when RDTOH becomes trapped, or the active-passive income threshold kicks in.
So, the first question that I would consider is whether the corporation becomes inefficient early or late in my career. If it is late career, then the impact of asset location is less.
Lifestyle options when the corporation become inefficient.
The corporation becomes inefficient because there is too much income coming in and not enough being flowed out to the owner. This is intentional. Corporations face light taxation to allow for more capital to re-invest and grow the active business. Hence, the RDTOH and passive income rules are meant to discourage us from using them as passive investment tax deferral vehicles. When these rules make the passive investments inefficient, we can attenuate that by earning less, spending more, or tax planning.
If the passive income is not an issue until late career. Glide smoothly.
The best option may be earning less. You may want to consider working less as you approach retirement. That not only preserves tax efficiency, but it also allows you to psychologically adjust to this life change. If you don’t want to work less or spend more personally and will have an obvious surplus, then donation of appreciated stock to charity is another excellent tax strategy. That is good financial stewardship and may also make you happier.
If inefficiency becomes an issue early or mid-career. Use your power.
Again, you may want to reflect on how you can use your financial power. That may mean working less or in areas that are rewarding but pay less. It could mean spending more or giving more. Many professionals may wish to continue earning, spending, and giving at their current levels or only make minor tweaks. This is where other tax planning options become important.
Tax planning products for mid-career corporate inefficiency.
This is often the situation where financial advisors will introduce products aimed at maintaining corporate tax efficiency. The two big ones are independent pension plans (IPPs) and whole life insurance. These can be used as deductions against corporate income. However, they both come with increased costs and complexity that may offset the tax savings.
Independent Pension Plans
An IPP is basically like an RRSP, except it is owned by the corporation. This allows slightly more money to be put into it using actuarial calculations and some special rules compared to an RRSP. The potential downsides are fees from actuarial calculations and potentially management. They are often marketed with fee-laden funds, but you could DIY. Putting more into an IPP also means less flexibility during drawdown compared to a corporation.
Whole life insurance
Whole life insurance is heavily marketed from the angle that the pay-out is largely tax exempt and also does not count as passive corporate income. It is also heavily marketed because it is a big money maker for those selling them. Further, these products are very opaque, making the potential benefit hard for third parties to assess.
The best attempt that I know of suggests that the tax savings are usually offset by the fees and expected returns. When these products are priced, the insurance premium and expected investment returns are taken into account. This makes the expected return low and more of an exposure to whether the actuarial calculations to set the policy play out as expected. Their best use is probably to cover the tax liability to avoid a forced sale of assets upon death (like a family business or real estate).
Tax optimized asset location to delay or avoid inefficiency.
The DIY tax planning approach to building your portfolio to delay corporate inefficiency has three major prongs.
Proactively use your personal account options.
Using an RRSP and TFSA are more tax efficient long-term and also divert investment growth from the corporation to other accounts. If you have a low-income spouse, then helping them to build their own lightly taxed personal cash account also provides more tax planning options and diverts from the corporation.
Use asset location tax optimization.
Diverting investments paying large foreign dividends or interest to personal accounts helps to reduce the corporate passive income. Eligible dividend paying investments may also boost efficiency in a corporation over your lifespan.
Consider using corporate class ETFs.
You may want to consider whether using Horizon’s all-in-one corporate class ETF instead of a conventional one in your corporation. That is a very simple approach. They have some additional risks from the swap (if National Bank defaults) or if Horizon’s corporate structure can’t manage all of the income. However, the potential tax efficiency gain is quite large for a corporation that will run into inefficiencies.
For those using asset location with multiple individual ETFs, then some of the corporate class ETFs are vastly more tax-efficient in a corporation. Even net of their higher management and swap fees. Use of the bond ETF, HBB, should not only decrease corporate passive income, but also make an asset location strategy more stable by removing the impact of interest rate volatility on optimal location.
Your accumulation plan impacts your drawdown efficiency.
If an asset location strategy is used, it can impact how you efficiently remove money from your accounts during retirement. Tax optimized asset location with a corporation in the mix usually results in more eligible dividend income in the corporation and less other income. That translates to more tax-efficient eligible dividend income flowing out of the corporation in retirement instead of less efficient ineligible dividends.
Another factor to consider is the old age security claw back. Dividends are grossed-up and applied as income to determine how much OAS is recovered (functionally a tax). This may or may not impact high-income professionals depending on their retirement income and spending. Reducing passive income in the corporation gives more flexibility in how you get money out as capital dividends instead.
Potential benefit of asset location for a corporation is variable.
The above factors mentioned make the potential magnitude of benefit for tax optimized asset location for a corporation highly individual. It depends on when the corporation becomes inefficient and whether you plan to address that with lifestyle modification, financial products, or asset location strategies.
This complexity is likely why no one writes about this. The complexity further contributes to the advice to “don’t bother”. However, let’s actually run some scenarios. It is extremely labor-intensive. So, I will use three representative ones to give some anchors that you can compare yourself against.
We will use three different high-income incorporated professional scenarios. For simplicity, let’s assume that they maintain constant earning and spending over their career rather than adjusting lifestyle. They are also not interested in using financial products such as an IPP or whole life insurance. Instead, they are DIY investors and are going to use Robocorp SWAT to do the math each time that they rebalance their portfolio.