How to evaluate different account (RRSP, TFSA, ...) and investment types (equities, bonds, cash) combinations

Question

If I make $1 tomorrow, I can put that $1 in several accounts:

• Personal non-registered account
• Personal RRSP account
• Personal TFSA account
• Pay down mortgage
• Leave in corporation and take out later

In each of these accounts I can choose from several investments:

• Equities - Canadian
• Equities - Foreign
• Dividend paying equities - Canadian
• Dividend paying equities - US
• Dividend paying equities - Foreign
• Bonds
• Cash

So now we have 4 accounts X 7 investment types = 28 options to consider (29 with the mortgage option and I am sure I am missing many other investment types).

How do I evaluate these options?

To simplify, I am looking at just the tax implications. Obviously there are a multitude of other factors to consider which would make this even harder. Any tools / methods / guidelines to help? I've started building a spreadsheet to model these options but it is time consuming to build.

Answer 1

This question is indeed rather complicated. Let's simplify it a little bit.

Paying down your mortgage makes sense if your expected return in the rest of your portfolio is less than the cost of the mortgage. In many cases, people may also decide to pay down their mortgage because they are risk-averse and do not like carrying debt. There's no tax benefit to doing so, though; Canada doesn't generally allow you to write off mortgage interest, unlike the U.S.

As to keeping money in the corporation or not, I'm not going to address that. I don't have a firm enough understanding of corporate taxation.

Canadian Couch Potato advises treating all of your investment assets as one large portfolio. That is what you are trying to do here. However, let's consider a different approach. If you do not have enough money to max out your RRSP or TFSA, you may choose to keep your TFSA for an emergency fund, where the money is kept highly liquid. Keep your cash in an interest-bearing TFSA, or perhaps invest it in the money market, inside your TFSA. Then, use your RRSP for the rest of your investment money, split according to your investment goals. This is not the most tax-efficient approach, but it is nice and simple.

But you are looking for the most tax-efficient approach. So, let's assume you have enough to more than max out your TFSA and RRSP contributions, and all of your investments are going toward your retirement, which is at least a decade away.

Because you are not taxed on your investment income from RRSPs (until you withdraw the money) or TFSA, it makes sense to hold the least tax-efficient investments there. Tax-advantaged investments such as Canadian equities should be held in your investment accounts outside of TFSA and RRSPs.

Again, the Canadian Couch Potato has a great article on where to put your investment assets. That article covers interest, dividends, foreign dividends, and capital gains, as well as RRSPs, RESPs, and TFSAs. That article recommends holding Canadian equities in a taxable account, REITs in a tax-sheltered account (TFSA or RRSP), bonds, GICs, and money-market funds in a tax-sheltered account (as these count as interest). The article goes into rather more detail than this, and is worth checking out. It mentions the 15% withholding tax on US-listed ETFs, for example.

In addition to that website, I recommend the following three books:

• Mutual Fund Investing for Canadians for Dummies
• Investing for Canadians for Dummies
• MoneySense Guide to the Perfect Portfolio (by the author of Canadian Couch Potato)

The above three resources strongly advocate passive indexed investments, which I like but not everyone agrees with. All three specifically discuss tax implications, which is why I include them here.

Answer 2

Not to state the obvious, but whenever an investment is being made, the "nuts and bolts" is your return on investment. Analyzing the rate of return on an investment is the primary factor in any decision. Ideally, once the actual mechanics of investment and side "benefits" are factored out, the goal is to be able to analyze the pure financial return.

Usually the biggest problem faced in analyzing various investments is comparing the Present Value of an investment to a series of payments that may be made or received in the future. When considering the purchase of a large equity, for example, you might be looking at what series of payments are required to purchase the asset. You can also reverse this and ask, "What amount of money is equivalent to this series of payments?"

Ultimately, the Present Value of an Annuity is the way to make these comparisons equal.

Fundamentally, the Present Value of an annuity is an amount of money that should, in theory, be equivalent to a series of payments. There is, for example, technically no difference between $1064.94 today and $100 a month for a year, at an interest rate of 1% per month. Grant you, most people would be happier with the money now, but that is what interest does - it compensates you for waiting on your money.

You can fire up a spreadsheet and calculate the Present Value as long as you have the monthly payment, interest rate, and number of periods. Alternatively, you can calculate any one of those missing four variables - and the key is usually to understand what that rate would be in order to compare the investments.

Finally, the taxable implication is really just an adjustment to the rate of return.

Imagine the following three scenarios:

1. You can invest $100 per month in a savings account returning 6% per year (yeah, right!)
2. You can pay down $100 per month of credit card debt with 6% interest rate
3. You can pay down $100 per month of mortgage debt that is due in a year at 6% interest.

(Obviously the rates are fictional - the goal is to show they are the same).

Scenarios 1 & 2 are really just two sides of the same coin. Using the Future Value formula in Excel = FV(0.5%, 12, -100), you get $1233.56. In scenario 1, you would have $1233.56 in your bank account. In scenario 2, your bank would have $1233.56 from you, and you would have $100 less debt per month. They are equivalent transactions.

Scenario 3 is really just a variation on scenario 2, localized to the United States. Because the interest is tax deductible, however, the rate of 6% isn't really accurate. Assuming you had a 25% tax bracket, you'd actually be getting back one quarter of your interest. Put another way, 7.5% mortgage interest costs you as much as 6% credit card debt.

This is how you compare apples and organges - just turn everything into an annuity or a lump sum, using Present Value calculations.

---

Finally, quick rule of thumb - if you owe taxes in both Canada and the US, your Canadian taxes are probably higher than your American ones. As such, any tax incentives will be concomitantly higher. If you only can only use Canadian tax incentives, then look to those incentives, other things being equal.