Taxable accounts have a few notable benefits. A big one is flexibility: Though you do have to pay taxes on investment gains, unlike tax-deferred accounts such as RRSPs, you can withdraw the money--contributions and earnings alike--whenever you need it, free of penalty.
Another plus is that there are no limits to how much you can invest in a taxable account (and you don't need to have earned income to contribute). TFSAs have an annual contribution limit of $5,500 that is cumulative, and RRSPs allow income earners to contribute up to 18% of their pre-tax earnings, within limits set each year (for 2017 it's $26,100).
The downside, of course, is taxes. Not only do you pay taxes on the way in, as contributions are made with after-tax dollars, but you also pay taxes on any amount that is above your cost basis when you sell. But on top of that, even if you don't sell, you will pay taxes on any income distributed from your investments held inside taxable accounts. That means if you hold dividend-paying stocks inside of taxable accounts, or if a mutual fund or exchange-traded fund you own in the account makes a capital gains distribution, you are on the hook to pay taxes on that income.
It's always a good idea to try to maximize your entire portfolio's tax efficiency by relegating more tax-efficient investments to your taxable account, while placing less tax-efficient investment types in a tax-deferred account. Here are some tips to help determine what goes where.
Index funds and ETFs tend to be tax-efficient
There are certain types of funds that are by design more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market capitalization, have fairly low turnover and tend not to pay out big distributions.
But don't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.
Likewise, exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, more investigation is warranted here, too; certain types of ETFs are more likely to make distributions, such as fixed-income ETFs, currency-hedged ETFs or ETFs that invest in markets that do not allow in-kind redemptions.
Sometimes market conditions can play a role in tax efficiency, too. For 2017, considering the strength of the U.S. stock market, it should come as no surprise that high-flying U.S. equity ETFs are slated to pay out the biggest distributions. For instance, iShares U.S. Dividend Growers Index ETF (CAD-Hedged) (CUD) is estimated to distribute about 10% of its net asset value.
Another noteworthy trend this year is capital gains among a crop of newer funds born into a bull market with higher turnover that have experienced one-directional flows since inception. As Ben Johnson, Morningstar's director of global ETF research, explains: "Higher turnover has forced them to sell lowish-basis securities, given that they haven't had much opportunity to purge them from their portfolios via in-kind redemption."
Actively managed funds, income-producing securities tend not to be as tax-efficient
On the other end of the spectrum, actively managed funds that tend to have high-turnover strategies can be tax-inefficient, because selling securities at a gain triggers a distribution.
Of course, though, this is a general rule of thumb that doesn't always hold true. If you are looking to hold an actively managed fund in a taxable account, looking at the fund's tax-cost ratio could be helpful.
Found on a fund quote's Tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions. The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. Note that the tax-cost ratio is not simply the difference between the pre-tax return and the after-tax return. This is the formula to calculate it:
Tax-Cost Ratio = [ 1 - ( (1+tax-adjusted return) / (1+pretax return) ) ] x 100
The example I linked to, Fidelity Canadian Large Cap, has a 10-year tax cost ratio of 1.20 and annual turnover of 79%; scroll down to the table at the bottom of the fund's Quote page to see its historical dividend and capital gains distributions. I probably would think twice before holding this fund in a taxable account.
But it also pays to remember that past isn't prologue. Actively managed funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. The tax-cost ratio is a helpful tool, but it's not a guarantee.
These rules of thumb are helpful when determining asset location, but none of them are guarantees. It's also important to remember that you probably shouldn't overhaul your portfolio for the sake of tax considerations, which are a shifting landscape anyhow. As Morningstar director of personal finance Christine Benz points out, proper asset location won't make or break your retirement plan in the way that your savings/spending rate and your asset allocation will.
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