Tax Efficiency and Asset Location

Income tax policy, rules, problems, strategy and software. Property and consumption taxes too.
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Tax Efficiency and Asset Location

Post by Park »

When it comes to asset location, maximizing the absolute amount of tax saved to maximize return is the priority of many. Sometimes people focus on the tax savings relative to the return of an investment. For example, assume 50% tax on fixed income and ordinary income, 25% on cap gains, and 35% on Canadian dividends. If returns are similar for each asset class, then saving tax on fixed income is the priority. But if returns are significantly greater for stocks, then the absolute amount of tax saved may be greatest by focusing on stocks. For a long term investor, stocks returns will most likely be eventually sufficiently greater than fixed income such that the tax efficiency priority should be stocks.

What is the most tax efficient vehicle to have an asset or subasset class in? What’s most important here is what income you will have after all taxes are paid. You may have an impressive RRSP, but if it gets taxed at 50% on withdrawal, it will be less impressive. This also applies to corporate accounts. To a lesser extent, this also applies to taxable noncorporate accounts, where unrealized cap gains will eventually be realized. For a long term investor, that tends to means stocks first in TFSA then taxable noncorporate then corporate then RRSP.

When it comes to tax efficiency and vehicle choice, there are two points, that may be underemphasized. ETFs are more tax efficient in general than MFs. With ETFs, I don’t have to pay cap gains tax when other investors buy and sell units/shares of the ETF, unlike MFs. With American domiciled ETFs, turnover within the ETF itself will tend not to result in cap gains due to the use of tax lots, unlike Canadian domiciled ETFs. This ability to use tax lots may be an advantage of wrap ETFs.

Within stock subasset classes, what should determine asset location? Each subasset class will likely have similar long term return. This assumes a couch potato investing strategy. Emerging markets might have a greater long term return, but that’s debatable. If returns are similar, what’s important then is how much of the return is cap gains and how much is dividends. It’s also important that Canadian stock dividends are taxed less than other stocks. Both have to be taken into account. EAFE dividends are higher than Canadian dividends and are taxed more. So EAFE dividends should have a higher priority than Canadian dividends. US dividends are taxed more than Canadian dividends, but US dividends are lower than Canadian dividends. So the absolute amount of tax saved is slightly greater by prioritizing Canadian stocks over US stocks.. When it comes to tax efficiency, the number one priority is EAFE stocks then emerging market stocks then Canadian stocks then US stocks.

A complication with RRSPs and TFSAs is that your tax rate at the time of contribution and also withdrawal is relevant. For example, if your tax rate at the time of contributing to your RRSP is 54% but is 0% at withdrawal, that’s relevant. Similarly, if your tax rate at the time of contributing to your TFSA is 0% but at withdrawal is 54%, that’s relevant. That’s one small advantage of being a higher net worth investor :-): you can probably make the assumption that the higher tax rates are what’s most relevant to you at the time of contribution and withdrawal.

Also, how long you are investing for is relevant. A 50% tax on RRSP withdrawal may at first glance suggest that stocks go in taxable over an RRSP. But assume you contribute at age 18 and withdraw at age 71. The tax free growth of RRSPs might overcome that 50% withdrawal tax handicap.
However, if you worry about whether stocks should go in taxable vs. RRSP vs. TFSA, you probably have a portfolio of moderate size at least. If you have a portfolio of such size, that means you’re likely an older investor. And if you’re an older investor, your time horizon until RRSP withdrawal will be shorter. For such an investor, the 50% withdrawal tax may be more important than the tax free growth of an RRSP.

For corporate accounts, nonCanadian dividends have an effective tax rate greater than in an open noncorporate account, whereas Canadian (eligible) dividends have the same tax rate. So the priority in corporate accounts should be Canadian stocks.

In an RRSP, US investments in US domiciled vehicles won’t be exposed to withholding tax on dividends. But in a TFSA, you’re exposed to that tax and can’t recover it. Still, the difference is small enough that it shouldn’t change your plan.

When it comes to OAS clawback, then Canadian dividends become less tax efficient, and the forced income of an RRSP can become important. I’m hoping to be in a higher marginal tax rate when I’m retired, so that won’t be an issue :-).

This all assumes that tax efficiency to maximize return is paramount. But for some, rebalancing is important. Rebalancing is primarily to manage risk. It’s reasonable to put a greater priority on risk management than return. In such cases, it makes more sense to put fixed income in taxable accounts and stocks in registered. With such an asset location, you can rebalance with the greatest tax efficiency.

For others, liquidity may be important. In such cases, fixed income should go in taxable accounts, as that will maximize tax efficiency when it comes to liquidity.
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Re: Tax Efficiency and Asset Location

Post by Park »

An issue with maximizing return using asset location is that it assumes static tax rates. Over long periods of time, that is very debatable.

None of what I've mentioned are my own ideas. Among others, I'd like to thank Justin Bender and his blog.

About tax rates at the time of contribution and withdrawal being important for RRSPs and TFSAs, it's also relevant to corporate investing. Corporate investing is similar to RRSP investing, although tax rates at the time of contribution and withdrawal are somewhat less important for corporate accounts.

I mentioned that "When it comes to tax efficiency, the number one priority is EAFE stocks then emerging market stocks then Canadian stocks then US stocks." The question of whether you own REITs or growth/value stocks is also relevant. REITs are tax inefficient, so they might be the number one priority. Value stocks tend to have higher dividends, so that would likely make them a higher priority.

Toward the end, I mentioned that risk management by rebalancing would be the priority for some, when it comes to asset location. Rick Ferri advocates having a similar asset allocation in each account, to optimize rebalancing.

At the end, I mentioned that liquidity would be the priority for some, when it came to asset location. If you're following Warren Buffett's 90% S&P500/10% short term government bond portfolio, this is relevant. The 10% bonds are designed to provide income when the stock market is in drawdown. In that case, you want those bonds to be liquid. The priority for liquidity should be noncorporate open, TFSA, corporate open and then RRSP. TFSAs aren't quite as liquid as noncorporate open account, as you have to wait until the next year to recontribute any withdrawals.

Assume you're following Warren Buffett's portfolio. When it comes to stocks, what is written about maximizing return using asset location is relevant.
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Re: Tax Efficiency and Asset Location

Post by longinvest »

Park,

What do you think of "equal location", where an investor uses the same asset allocation in each of his accounts?
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Re: Tax Efficiency and Asset Location

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When it comes to asset location, if one's priority is risk management, then equal location sounds like a good idea.

The optimal asset location depends on what the goals of the investor are.
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Re: Tax Efficiency and Asset Location

Post by longinvest »

Park wrote: 26 Aug 2017 18:24 When it comes to asset location, if one's priority is risk management, then equal location sounds like a good idea.

The optimal asset location depends on what the goals of the investor are.
Thanks.
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Re: Tax Efficiency and Asset Location

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An advantage of having fixed income in noncorporate open accounts is that the range of available fixed income products might be greater in such an account compared to other accounts.
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Re: Tax Efficiency and Asset Location

Post by Park »

https://www.canadianportfoliomanagerblo ... be-broken/

Interesting analysis from Justin Bender on effect of province/territory, when it comes to maximizing return by tax efficient asset location. Asset location will depend to some extent on dividend tax rates in your province/territory, which results in asset locations not being uniform across Canada. He also points out that the MERs, withholding taxes and ability/inability to recover those withholding taxes may influence asset location.
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Re: Tax Efficiency and Asset Location

Post by DenisD »

I've been doing some VPW type scenarios in the past few weeks. Looking at how much I can spend if I start running down my portfolio instead of keeping it at a steady value. I've been taking into account taxes and RIF withdrawals. Another spreadsheet. In most cases, I end up with most of my money in my TFSA.

Of course, I assume the government rules stay the same for the next 30 years, from age 70 to 100. Not very realistic. But the best I can do.

One of the things I looked at was how fast to move my equities from nonregistered to TFSA. Move them as fast as possible? Or keep them in nonregistered as long as possible? I found it was better to keep them in nonregistered. But not by much.

Two of the most important factors to consider are the level of income from equities and the amount of unrealized capital gains. If the income is low and the ACB is low, it's better to keep equities in nonregistered. If the income is high or the ACB is high, it might be better to move them.

If you have a long term equity ETF investment with low distributions, it's almost like having another RSP. But you don't have compulsory withdrawals and the tax rate is halved. If you're running down your portfolio, your tax rate is going down. You'll pay little or no tax when you sell the last units of your ETF. It's almost like having another TFSA. :wink:
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Re: Tax Efficiency and Asset Location

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Two of the most important factors to consider are the level of income from equities and the amount of unrealized capital gains
Maybe not the income but the capital gain part can be somewhat controlled by using multiple ETF's bought at different periods of time that cover the same index.
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Re: Tax Efficiency and Asset Location

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DenisD wrote: 28 Aug 2017 23:48
One of the things I looked at was how fast to move my equities from nonregistered to TFSA. Move them as fast as possible? Or keep them in nonregistered as long as possible? I found it was better to keep them in nonregistered. But not by much.
How can anything be better than tax free?

You have to take a tax hit to move from one to the other but if the investment continues to grow I think the tax hit today would win out in the long term.

Always considered the TFSA as the best place for any investment.
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Re: Tax Efficiency and Asset Location

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BRIAN5000 wrote: 29 Aug 2017 00:08Maybe not the income but the capital gain part can be somewhat controlled by using multiple ETF's bought at different periods of time that cover the same index.
I'm looking at existing investments. That is, some of them I bought years ago. That's why the ACB is low.
deaddog wrote: 29 Aug 2017 00:13 How can anything be better than tax free?
Tax next year is better than tax this year. And my gains are compounding tax free until I sell.
Always considered the TFSA as the best place for any investment.
But the question is, which investment. I have other stuff I can put in my TFSA.
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Re: Tax Efficiency and Asset Location

Post by adrian2 »

deaddog wrote: 29 Aug 2017 00:13
DenisD wrote: 28 Aug 2017 23:48
One of the things I looked at was how fast to move my equities from nonregistered to TFSA. Move them as fast as possible? Or keep them in nonregistered as long as possible? I found it was better to keep them in nonregistered. But not by much.
How can anything be better than tax free?
In addition to Denis' answer, negative tax is better than tax free. :P
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Re: Tax Efficiency and Asset Location

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DenisD wrote: 29 Aug 2017 00:33
deaddog wrote: 29 Aug 2017 00:13 How can anything be better than tax free?
Tax next year is better than tax this year. And my gains are compounding tax free until I sell.
Agreed.
Always considered the TFSA as the best place for any investment.
But the question is, which investment. I have other stuff I can put in my TFSA.
Your highest returning investment. In my case an actively traded equity account.

Cap gains in a non registered account may lead to a reluctance to take profits in a timely manner because of tax concerns. The beauty of the TFSA as a trading vehicle is that taxes don't enter into the equation at all.
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Re: Tax Efficiency and Asset Location

Post by deaddog »

adrian2 wrote: 29 Aug 2017 10:42
deaddog wrote: 29 Aug 2017 00:13
DenisD wrote: 28 Aug 2017 23:48
One of the things I looked at was how fast to move my equities from nonregistered to TFSA. Move them as fast as possible? Or keep them in nonregistered as long as possible? I found it was better to keep them in nonregistered. But not by much.
How can anything be better than tax free?
In addition to Denis' answer, negative tax is better than tax free. :P
True if your income is low and you have dividend income. Not in my case. Probably not in yours. :)
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Re: Tax Efficiency and Asset Location

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deaddog wrote: 29 Aug 2017 10:50 The beauty of the TFSA as a trading vehicle is that taxes don't enter into the equation at all.
According this article by Jamie Golombek, Stop using your TFSA to frequently trade stocks — the CRA may see it as taxable business income | Financial Post
Jamie Golombek wrote:Under the tax rules, if a TFSA carries on a business then it must pay income tax on its business income. This has been a focus of recent audit and reassessment activities where the Canada Revenue Agency has been targeting taxpayers who actively traded securities in their TFSA.

Last week, at the annual conference of the Society of Trust and Estate Practitioners held in Toronto, the CRA was asked to provide an update on the result of its audits and whether it has any plans to educate the public on what the acceptable limits are on securities trading to prevent a TFSA account from being considered to be “carrying on a business.”

<snip>

The factors that the CRA looks at include: the frequency of the transaction; the duration of the holdings; the intention to acquire the securities for resale at a profit; the nature and quantity of the securities; and the time spent on the activity.
I'm a buy and hold investor, so don't worry about these details. However, from my read of the Golombek article, one could make the argument that using the TFSA as a trading vehicle could definitely bring taxes into the equation.
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Re: Tax Efficiency and Asset Location

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deaddog wrote: 29 Aug 2017 10:54kelowna
True if your income is low and you have dividend income. Not in my case. Probably not in yours. :)
Somewhere in the $100k taxable income range depending on province, DTC dividend and cap gains rates cross. Too many people fail to qualify DTC benefits.
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Re: Tax Efficiency and Asset Location

Post by SQRT »

AltaRed wrote: 29 Aug 2017 11:36
deaddog wrote: 29 Aug 2017 10:54kelowna
True if your income is low and you have dividend income. Not in my case. Probably not in yours. :)
Somewhere in the $100k taxable income range depending on province, DTC dividend and cap gains rates cross. Too many people fail to qualify DTC benefits.
Sounds about right, but some of your proceeds of disposition will be return of capital so the tax on divs will be higher. When I retired in 2006, the max rates in Alberta were about equal if you ignore any return of capital- ie around 17-19.5%. Now they are 24% and 31.7%. Big difference.
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Re: Tax Efficiency and Asset Location

Post by Park »

I'm reading "The New Wealth Management" by Harold Evensky et al. Some relevant point are made about taxable investing.

The risk adjusted return of stocks improves relative to that of bonds in a taxable account compared to a tax advantaged account. Risk adjusted return is usually some measure of return divided by volatility. Real returns are what interests investors, not nominal returns. So real return is divided by volatility. In a taxable account, both return and volatility will be decreased by tax. However, you'll still get taxed on the inflationary portion of return. So the real return will be reduced by both the tax on the real return and the inflationary return. In a taxable account, the ratio of return to volatility will be lower than in a tax advantaged account. Assume tax rates are the same for stocks and bonds. The tax on inflationary return will be the same for both stocks and bonds. Assume stocks do better than bonds, which historically they have. Tax will decrease the real return of bonds by a greater % than the real return of stocks. If bonds are taxed more than stocks, this difference will be more yet.

A related point is that relative to stocks, bonds are more exposed to inflation risk in a taxable account compared to a tax advantaged account. This assumes that stocks do better than bonds, and that stocks aren't taxed more heavily than bonds. Once again, the tax on inflationary return will be the same for both stocks and bonds. Stocks will have greater ability to absorb that tax on inflation than bonds. Both stocks and bond will be exposed to inflation rate more in a taxable account, compared to a tax advantaged account.

Another aspect of asset location is tax loss harvesting. As Evensky et al point our, the most tax loss harvesting opportunities come with volatile negatively correlated securities. That describes stocks more than bonds. It's another reason to consider stocks in your taxable accounts.
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Re: Tax Efficiency and Asset Location

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Park wrote: 09 Oct 2017 02:39Both stocks and bonds will be exposed to inflation rate more in a taxable account, compared to a tax advantaged account.
I can't modify my own posts anymore, so I had to create a new one. The following is obvious, but I don't think it gets discussed as much as it should. Tax advantaged accounts decrease your portfolio's exposure to inflation risk. That's because you're less exposed to the tax on inflationary returns. So with a TFSA, you'll never get exposed to that tax on inflationary returns. But with an RRSP, you'll delay that exposure. Eventually, you'll pay tax on the inflationary return. But you won't be exposed to the negative compound effect of that tax on inflationary returns, until you're in the withdrawal phase. This is particularly relevant to those in higher tax brackets owning nominal bonds.
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Re: Tax Efficiency and Asset Location

Post by BRIAN5000 »

It's OK to sell some stocks in the TFSA and withdraw the money, then sell some bonds to buy stocks in the RRSP, to bring back the overall portfolio to its target 50/50 allocation.
It maybe ok but not Ideal?

I've got a little problem that's sort of similar this isn't a large amount of money in between $25 and $100 grand range. Sometimes things are just in the wrong account. I'm doing some rebalancing and would like to sell stocks and buy some fixed income, I'm a little more than 5% overweight equity. Stocks I could sell are in my account and will attract capital gains tax. I could sell stocks in my TFSA and/or the wife's or daughter's TFSA( her account my money) but that would leave those accounts mostly fixed income with zipolla for growth in those accounts. I would prefer to leave more equity in wifes accounts so her portfolio has a chance to grow more/faster than mine to equal out portfolios a bit.

So do I sell stuff in my name and pay the taxes or sell anything/everything in the TFSA's that doesn't attract any tax first?
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Re: Tax Efficiency and Asset Location

Post by Quebec »

Reviving an old topic, as the title fits with my question. Totals may not always add up to 100% due to rounding.

Context:
Asset allocation:
* 35% Canadian fixed income (mix of GICs , nominal bond ETF, RRB ETF)
* 20% Canadian Equities
* 20% US Equities
* 20% International (EAFE) equities
* 2% REITs
* 3% gold
(please don’t comment on this, I’m happy with it, the question is about asset location)

In maybe a year, I will get an inheritance. We’re planning to go on a nice trip with the family, pay back most of our remaining mortgage (whatever I can pay without penalties), and there will still be a nice amount left to invest. But it will have to be non-registered, since all our registered accounts are full. Nice problem to have, I know.

At the moment, our non-reg investing represents about 10% of our total portfolio (all in my wife’s account!), so it consists almost entirely of Canadian equities. The rest of the Canadian equities, and all the other asset classes, are distributed without much thought within the registered accounts (2 RRSPs and 2 TFSAs). This is the result of investing new cash in whatever asset class is below target at that particular time. But the sudden cash infusion will cause the non-reg portion to grow to over one third of the portfolio, so this is a perfect opportunity for an optimization exercise across all 6 accounts. The overall allocation will stay the same (just larger dollar amounts). The post-inheritance account split will look something like this:
* Non-reg accounts: 36% of total portfolio
* RRSPs: 37%
* TFSAs: 27%
With meaningful TFSAs, it’s not just registered versus non-registered, it’s also RRSP versus TFSA…

Current plan:
* 20% Canadian Equities: all in non-reg (VCN or similar)
* 20% US Equities: all in RRSPs (VTI)
* 20% International equities: 16% ZEA in non-reg, 4% VEA in RRSP
* 35% Canadian fixed income: 12.5% in RRSP and 22.5% in TFSA (details of specific funds unimportant here)
* 5% Gold + REITs: all in TFSA

(I only use US-listed ETFs when they are significantly cheaper (including the effect of foreign withholding taxes) than TSX-listed, CAD-denominated equivalents, since even with Norbert’s Gambit, the currency exchange costs are not zero; I used total costs from Bender & Bortolotti’s white paper)

Here is how I got there:
* Fixed income goes into registered accounts (avoid non-reg due to interest income taxed at MTR in Canada; I have yet to be convinced that the old rules don’t apply anymore)
* It does not matter which registered account the fixed income goes into, and there is plenty of registered room available for it, so we can mostly deal with the equities first
* The non-reg accounts will be all equities and there will be taxes to pay in Canada on this account (dividends and cap gains); so place Canadian stocks in non-reg (dividend tax credit), but don’t worry about Canadian taxes beyond that, since they can’t be avoided
* Next decision is where to place the US and international equities, and this is where foreign withholding taxes come into play
* US equities are happy in RRSPs due to no foreign withholding taxes on VTI there
* Avoid TFSAs for international equities because of withholding taxes which can’t be recovered; non-reg is good since foreign taxes will be credited; RRSP OK too (same cost as non-reg), but need to leave room in RRSP for fixed income, so international equities go mostly into non-reg, until this account is filled
* Not much room left in RRSP at this stage, so place fixed income there until RRSP is filled
* TFSA ends up consisting of fixed income + gold + REITs

Please criticize the reasoning and the current plan.
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Re: Tax Efficiency and Asset Location

Post by Mordko »

Do you expect equities to grow more than FI and gold? If so then your plan will lead to more tax being paid than if you were to put FI and gold into non-reg.

Understand that interest is taxed at a higher rate, but this effect is normally overwhelmed by having to pay tax on capital gains and growing dividends. This argument is stronger for TFSA but even RRSP room with its deferred taxation is more efficiently used for equities under most scenarios. REITs probably should be held in a reg account because taxation is a nightmare and they behave like equities
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Re: Tax Efficiency and Asset Location

Post by Koogie »

Perhaps you should also explain where in your lifespan/investing life cycle you are ? As you know, there are a lot of different considerations for a 35 year old versus a 65 year old.

For instance, being of a similar age I would agree with Mordko that registered room should not be wasted on low paying FI. However, older board members do keep their FI in registered accounts.
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Re: Tax Efficiency and Asset Location

Post by longinvest »

Quebec wrote: 17 Nov 2019 09:02 Please criticize the reasoning and the current plan.
Not a criticism. Just a few annoying questions. You don't need to tell us the answers. :wink:

Are you sure that the complexity of this carefully designed 62/35/3 equities/fixed-income/gold portfolio brings any significant improvement over a much simpler all-VBAL portfolio? (You don't need this hint, but other readers might.)

Have you thought about your surviving spouse? Maybe you've written instructions for your spouse to move the portfolio into VBAL after you're gone. But, do you really want to burden your surviving spouse with such a considerable portfolio change? You won't be able to hold your spouse's hand to help proceeding with the suggested change, once you're gone.

Good luck!
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Re: Tax Efficiency and Asset Location

Post by ig17 »

I think it's a waste to put FI and gold in TFSA. I use TFSA for high growth equities where I expect big capital gains decades from now. I don't plan to change this when I retire in 3-5 years.
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