# Portfolio allocation and tax effiency

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asked Mar 06, 2017 01:13 PM by

Hi Jin,

Long time reader, first time poster. Thanks for your blog and all the useful information it contains. I discovered this site through your post on couchpotato portfolios (nice move!). To me, the fact that your website provide freely this much information is a key factor to change the world of personal savings / investing. It becomes more and more understandable to every one and I know that I owe you a lot, not only metaphorically!

Today I’ve decided to ask my silly question about tax efficiency portfolio allocation. I’ve read the post on how the tool works (multiple times) but there is still something I don’t get:

TFSA 1. IVAL 2k US 2. QVAL 10.6k US 3. BRK-B 7.4k US

RRSP 1. IVAL.  9k US 2. XEG.TO 7k5 3. CGL-C.TO 5k 4. XSB.TO 5k

• I find logical to see BRK-B in TFSA: since it does not pay dividends, there is no need to avoid the foreign withholding tax in RRSP.
• I would have expect to see QVAL in RRSP (still to avoid paying the foreign withholding tax)
• What is the reason the tool choose not to have XEG.TO / CGL-C.TO & XSB.TO in TFSA? Aren’t Canadian stocks / bonds supposed to be hold in TFSA?

Here’s the type of allocation I had in mind before checking the tool:

TFSA 1. XEG.TO 7k5 2. CGL-C.TO 5k 3. XSB.TO 5k 4. BRK-B 7.4k US

RRSP 1. IVAL.  11k US 2. QVAL 10.6k US

Thanks for answering my questions Julien

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answered Mar 08, 2017 02:31 PM by

Hi jfraisse,

Part of the reason why you see such computed allocations is due to the limitations of our algorithm. In order to complete the calculations quickly, it lumps all Canadian investments into one as if it were just a single investment. The same applies to U.S. investments.

However, the bigger reason why you see the computed allocation is because dividend taxes are not the only consideration. Different investments have different expected rates of return. Depending on your personal situation, it may make sense to put U.S. stocks and ETFs in the TFSA if you think the expected returns are higher, despite the higher tax rate on dividends.

Let me show you why using a basic example. Let's suppose you expect a U.S. stock to return 10% per year forever, and you have 28 years to invest it. Then, your stocks will have doubled 4 times in 28 years, so you'll get 16x the initial money you invest.

If you put all that money in an RRSP, and if you start with a decent amount, then you'll have a big RRSP account in 28 years. For example, if you start with $100,000 today, then you'll end up with$1.6 million in 28 years. If you try to withdraw a significant percentage of this money every year starting in year 28, then it's likely that you'll pay a high tax rate on your withdrawal.

But what happens if you think you'll only get a 5% rate of return? Then, your RRSP is expected to only double twice in 28 years, which means you'll get 4x the initial money. If you start with $100,000, you'll end up with$400,000. With that sum, you'll probably pay a lower tax rate on your withdrawals.

On the other hand, the future size of your investments don't matter for TFSAs, since the you'll be able to withdraw all the money tax free. Therefore, it often makes sense to put high return investments in TFSA, and put lower return investments in RRSPs.

The U.S. investment components of Regular portfolios generally have high expected returns. BRK-B, QVAL and IVAL all extensively use value investing strategies, and I believe such strategies will give us better than average returns. The benefits of putting high return investments in your TFSA may outweigh the drag from dividend taxation, so that may be why you're seeing U.S. investments in your computed allocation.

I hope that makes sense,

Jin

1

The bigger picture behind this allocation is to get the bigger TFSA possible in order to avoid incomes taxes when withdrawing from your RRSP when you retired. And to do so, it logically puts in the TFSA all the investments with the higher expected return. Thanks for the clarification, very clear!

( Mar 08, 2017 02:57 PM )edit

My pleasure!

( Mar 08, 2017 05:50 PM )edit