We all understand the importance of location when evaluating the potential future value of real estate. A similar analogy can be made for your investments. However, in this case, we’re not talking about the geographic location, but rather in what type of account your investments are held. The location of your investments can effectively have a significant impact on the future value of your portfolio.

Investment portfolios are generally divided between two large asset classes: equity and fixed income. While equity investments have higher short-term volatility of returns, they will perform better than fixed income over the long term. The percentage you allocate to each asset class will depend on your goals, age, risk tolerance and income requirements. In addition to returns and volatility, another important difference between these two asset classes is the way their respective income or returns are taxed. Equity generates dividends and capital gains, which are taxed more favourably than the interest income generated by fixed income investments. The top marginal tax rates in New Brunswick for 2007 are 46.95% for interest, 23.18% for eligible dividends and 23.48% for capital gains. This significant difference in the amount of taxes to be paid depending on the type of income is the reason why « asset location » can be so important.

Investors generally have two « baskets » in which to hold their investments: an RRSP account and a non-registered (taxable) account. The returns within an RRSP account grow tax free, and withdrawals in the future will be taxed as regular income. Income earned within a non-registered (taxable) account is treated differently. In this type of account, taxes are paid annually on the income and gains earned in the calendar year and no tax is paid on withdrawals, as this money has already been taxed.

From a tax perspective, one should be indifferent in generating interest, dividends or capital gains within an RRSP account, as no tax is paid on these amounts and withdrawals are taxed as regular income regardless of how the returns were generated. For non-registered (taxable) accounts, the story is quite different. As we explained, dividends and capital gains, which are generated by equity investments, are taxed much more favourably than interest income. Therefore, as a rule of thumb, one should try to hold equity investments within non-registered accounts in order to benefit from this favourable tax treatment. On the other hand, interest-bearing investments, such as bonds and GICs, should be held in registered accounts (RRSP, RRIF) as much as possible.

The benefit of paying attention to tax efficiency can be significant. Over a 15-year period, the after-tax value of a properly constructed portfolio can be as much as 10% to 15% more compared to a portfolio that is not constructed tax efficiently.

The above example is a simple one to illustrate the concept. In reality, for high net worth investors, the number of « baskets » or « locations » where investments can be held also includes a holding company, universal life insurance policy, family trust or other types of accounts. The taxation of investments within these different « baskets » must be considered when building a tax-efficient portfolio.

A lot of attention is placed on the nominal returns generated by our investments. However, as you can see, other factors, such as the location of assets, will have a significant impact on what is left after tax. Luc Gaudet, CFA, is Vice-President and Chief Executive Officer at Louisbourg Investments Inc.