Pre VS After Tax Asset Allocation - YouTube

Today I am going to tie together  some of the topics that we have  

covered recently. If you have not  watched my videos on asset location  

or asset allocation you may want to  check those out before watching this.

In brief, asset allocation is deciding which  asset classes should make up your portfolio,  

and asset location is deciding which accounts  those asset classes should be owned in. I often  

advocate maintaining the same asset allocation in  all account types. If you choose, for example, to  

hold all of your bonds in your RRSP account, you  are introducing an often overlooked side effect.

I’m Ben Felix, Associate Portfolio Manager at PWL  

Capital. In this episode  of Common Sense Investing,  

I’m going to tell you how your asset location  might be throwing of your asset allocation.

If you own assets in your RRSP you have  to remember that you only own part of  

them. The government is entitled to some  percentage of everything in that account  

depending on your circumstances  when you make RRSP withdrawals.

Believe it or not, this plays a role in  your asset allocation. Let’s take a look  

at an example to wrap our heads  around what I am talking about.

To keep things simple let’s assume that  you have $50,000 in an RRSP and $50,000  

in a TFSA. If you have a 30% tax rate at  withdrawal, your RRSP is worth $35,000  

after-tax. If you hold all of your bonds in  your RRSP and all of your stocks in your TFSA,  

your pre-tax asset mix is 50% stocks and  50% bonds, but your after-tax asset mix  

is about 59% stocks and 41% bonds due to  the tax liability in the RRSP account.

Let’s assume stocks return 5% and bonds  return 3% and look 1-year out. The $50,000  

in your RRSP would be worth $51,500 and  your TFSA you would be worth $52,500.  

After accounting for the 30% tax liability  in the RRSP, your take-home is $88,550.

If you hold the same asset mix in both accounts,  then your pre-tax and after-tax asset allocations  

are the same. You are paying equal amounts  of each asset class to the government,  

as opposed to only paying the government from  your bond allocation in the previous example.

If after-tax asset allocation  is the only thing that matters,  

then we would expect a 59% stock an  41% bond mix split equally across  

the RRSP and TFSA to give us the same  after-tax result as our first example.

In this case we will have $29,411 in stocks and  $20,588 in bonds pre-tax in both the RRSP and  

the TFSA. Assuming the same 5% return for  stocks and 3% for bonds, after 1-year the  

RRSP and TFSA are each worth $52,088 pre-tax.  Paying 30% of the RRSP to the government leaves  

us with a total after-tax amount of $88,550,  which is identical to our previous scenario.

Despite having a different pre-tax asset  allocation in the two examples so far,  

we have demonstrated that it is the after-tax  allocation that determines the end result for  

after-tax dollars in your pocket. Now let’s  look at another example where we take our  

intended 50% stock and 50% bond allocation  but hold it in equal proportions in both  

accounts. We will have $25,000 each in stocks  and bonds in both the RRSP and TFSA account.

Note that our pre-tax allocation of 50% stocks  and 50% bonds is the same in this example as it  

was in our first example where we had $50,000  in bonds in the RRSP and $50,000 in stocks in  

the TFSA. The big difference and the point of  the example is that the after-tax allocations  

are different. Remember that the after-tax  allocation of our first example ended up  

being about 59% stocks and 41% bonds when the  tax bill on the RRSP was taken into account.

In this example, with an equal split of  stocks and bonds in both the RRSP and TFSA,  

our overall allocation stays the same before  and after tax. That means a 50% stock and  

50% bond after-tax allocation. Running this  through with our expected return assumptions,  

we will see the impact on the after-tax dollars in  your pocket. In this case we end up with $88,400,  

notably less than in our previous examples which  had higher after-tax allocations to stocks.

There is one more scenario that we can run to  drive this home further. If we start with $50,000  

of bonds in the RRSP account, $7,500 in bonds  in the TFSA, and $42,500 of stocks in the TFSA,  

we have a pre-tax asset allocation of 42.5% stocks  and 57.5% bonds which translates to 50% stocks and  

50% bonds after-tax. Running this ahead one year  we end up with an after-tax value of $88,400.

I know this can be a bit of a challenge to wrap  your brain around. The main takeaway is that  

what really matters to you is your after-tax  asset allocation. Based on this it would be  

sensible to estimate your after-tax allocation  and ensure that it matches your risk profile.

In practice I think that a lot of people look  only at their pre-tax asset allocation. If you  

have tried to optimize your asset location  by holding most or all of your bonds in your  

RRSP account, you would have an asset  allocation that may be more aggressive  

than you had intended. Now maybe this  is not such a bad thing as it leads  

to higher expected returns due to a more  aggressive than intended asset allocation.

Taking into account after-tax asset allocation  does add further complexity to the portfolio  

management process which I believe adds to the  challenge of optimizing asset location for any  

investor. All of these issue go away when  you hold the same asset mix in all accounts.

Does your after tax asset allocation match your  risk profile? Tell me about it in the comments.

Thanks for watching. My name is Ben Felix  of PWL Capital and this is Common Sense  

Investing. I will be talking about a new  common sense investing topic every two weeks,  

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