How taxes impact asset allocation

When investors look at options for additional retirement income, they often consider taking on more portfolio risk by increasing their equity allocation. But the relationship between a change in pre-tax asset allocation and after-tax income isn’t a simple one.

Read: Institutional investors turning to riskier assets: survey

“A full accounting of the impact of taxes should include the impact of taxes not just on withdrawals but on deposits and the tax deferral in between,” says Graham Westmacott, a portfolio manager at PWL Capital, in blog post.

For instance, because stocks and bonds have different tax treatments, the associated asset mix within various accounts — RRSPs, TFSAs and corporate holdings — must be considered.

Read: Are glide path portfolios better than constant equity portfolios?

To do this, convert a dollar deposited in a tax-advantaged account to an equivalent amount deposited in a taxable account that would generate the same after-tax retirement income. This is the tax equivalent wealth of the accounts.

“The asset location decision between the tax equivalent wealth accounts can be considered independent of the asset allocation decision,” says Westmacott.

Using a simple portfolio example, he illustrates the different contribution amounts necessary in both an RRSP and a taxable account to get the same after-tax benefit, accounting for the value of deferred tax within the RRSP and the benefit of contributing pre-tax dollars.

Not only is the difference in amounts significant, but the tax-equivalent asset allocation differs from the pre-tax asset allocation.

The bottom line: Comprehensive financial planning must account for the interplay of all factors that contribute to retirement income, says Westmacott.

Read the full blog post.

Also read:

RRSPs, RRIFs and fee deductibility: what you need to know

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.