The previous page on Asset Allocation calculations argued that when calculating the $$ investments for any chosen Asset Allocation (AA) it is only the part of the RRSP account that is ‘your money’ that should be included. The RRSP account should be discounted by some estimate of its withdrawal tax. Some people argue that the Taxed account should similarly be discounted by the effective tax rate on investment profits. Their argument is false because it confuses the AA issue by adding differing Asset Location (AL) benefits. To understand the following argument you must also understand the AL issue. The following examples all use the same set of assumptions over a one year period.
| 15% | Tax rate on profits of all kinds. A different rate only confuses your understanding. |
|---|---|
| 40% | Tax rate on RRSP withdrawals |
| $1,000 | Wealth split between two accounts |
| $500 | in RRSP. After 40% withdrawal tax = $300 wealth |
| $300 | in either a TFSA or Taxed account |
| 50 / 50 | Asset Allocation debt / equity. Prioritize debt in the Taxed account |
| 5% | Rate of return earned by debt |
| 10% | Rate of return earned by equity |
……….. Their argument ………………..
Their argument sounds very similar to the argument for discounting the RRSP account. Since the government has a claim on profits in a Taxed account, not all the profits are ‘yours’. If the effective income tax on the profits is 15% then only 85% of the profits are ‘yours’. If only 85% of the profits are ‘yours’ then only 85% of the asset is ‘yours’. Since the objective of AA is to allocate ‘your’ wealth only the 85% of the Taxed account should be included in calculations.
First they create a benchmark $641.63 outcome that results when each account is independently asset allocated – each with its own 50 debt / 50 equity split. For now ignore the blue total.
In examples B and C they AA across the portfolio in total, prioritizing debt in the Taxed account. They show that by discounting both RRSP and Taxed accounts in the calculations, the $641.63 outcome doesn’t change. They take this equal outcome as proof that the Taxed account should be discounted.
……….. Correct analysis ………………..
You can predict the $ outcome of the benchmark directly without all the fuss shown above.
i) Wealth at the start = $600. That is the $300 wealth in all accounts.
ii) The total profit would be 7.5%. Half at 5% from debt, and half at 10% from equity.
iii) The income tax on profits in the Taxed account would be $3.375 (= $300 * 7.5% * 15%)
iv) Wealth at the end = $641.625 (= $600 * (1+7.5%) – $3.375)
But should the outcomes be the same when you Asset Locate? No. The point of AL is to minimize taxes. Putting low-return debt in the taxed account should create a larger benefit from AL. Line (iii) above calculates the $tax on 7.5% profits (the debt/equity average). Now the 10% profits are sheltered from tax in the RRSP or TFSA, and only the 5% profits are taxed. When debt is Asset Located in the taxed account the $tax would be only $300 * 5% * 15% = $2.25. The ending Wealth should be $600 * (1+7.5%) – 2.25 = $642.75.
Examples D and E mirror B and C except that the Taxed account is NOT discounted. Their ending wealth is the correct $642.75 that reflects the greater profit sheltering benefit from AL. At the bottom of the benchmark and D and E, the AL benefits are subtracted from the $ outcomes. The equal Asset Allocation objective is accomplished.
You can play with the numbers on this spreadsheet. Try reversing the rates of return for the assets. The benchmark $642.75 outcome would not change because there, each account has the same allocation of assets as before. But now in examples D and E, allocating the low-return asset to the tax shelters means that less $profits (only 5%) are sheltered from tax. The AL benefit has been reduced. The outcomes should be worse than the benchmark, and they are. But the reason for the worse outcomes is all attributable to the wrong AL choice. The equal Asset Allocation objective was accomplished.
The B and C examples prove that THAT methodology (where the Taxed account is discounted) effectively zeros out the benefits from Asset Location. If you don’t want to realize AL benefits then you should KISS. Apply the same AA percentages to all your accounts separately, like the Benchmark example, and forget all about AL and forget all about the issue of ‘what account to discount’ in the AA calculations.
But since Asset Location does create benefits, why throw them away?
