Tax Efficient ETFs for Lazy Investing

Disclaimer: The information in this article is for information and educational purposes only. Your tax situation and the best tax mix for you can vary a lot by income level, province, and other personal factors. The content in here is very generalized. Talk to your accountant (a real CPA) for individualized advice.

Since you are presumably earning higher income at full tax rates while you are working and saving money, it is important to minimize your tax bill during these years. Compounding returns means every dollar you pay in tax along the way costs much more than a dollar down the road.

At a 6% annual rate of return, your investments should double every 12 years. Over a 40 year career, a dollar lost to taxes when you're 25 is worth $10 when you turn 65. That's after adjusting for inflation!

With this in mind, we are going to focus on tax-advantaged investments: deferred capital gains and Canadian dividends. We want to avoid interest income, foreign dividends, Other Income, and—if we're early in our investing years—RoC distributions.

Choosing Swap-Based ETFs

I personally invest in ETFs: low-cost, index ETFs to be exact. I also believe in diversification: we want to hold bonds and foreign stocks.

How do we maintain broad diversification, while indexing, without realizing income along the way?

On the Canadian stock exchange, we can invest in swap-based ETFs offered by Horizons. These lower-cost ETFs use a counter-party (typically a large bank) to establish an index fund. All distributions of the holdings are rolled into the counter-party's fund and reflected on the ETF unit as a simple increase in unit value—or a potential capital gain. For this reason Horizons swap-based ETFs do not pay distributions. Instead they track the total return of an index after fees. It's 100% legal and I believe it's very safe.

In Horizons Canadian Bond Fund ETF (trades as HBB.TO), high tax interest income is converted into low tax capital gains. It very closely tracks the total return of the comparable iShares Canadian Universe Bond ETF (trading as XBB.TO).

Likewise for the Canadian TSX 60 index funds. Horizons' ETF (trades as HXT.TO) converts dividends into capital gains. It has actually outperformed the comparable iShares TSX 60 ETF (trades as XIU.TO).

Same story for the S&P 500 ETF: HXS.TO, and the brand new Eurostoxx 50 ETF: HXX.TO (both swap-based ETFs from Horizons).

As long as you don't sell them, these great products allow us to defer capital gains taxes forever. All we have to do is contribute, invest, and balance. We can hold Canadian stocks, US stocks, European stocks, and bonds in the correct amounts.

To be somewhat similar to the Growth Portfolio, you can hold them in this allocation:

  • 40% HXS.TO
  • 20% HXX.TO
  • 20% HXT.TO
  • 20% HBB.TO

What About The Canadian Dividend Tax Credit?

Realizing Canadian dividend income in retirement is great. For individual income under $46,000, tax rates can actually be negative after the tax credit. However, at higher income levels this credit shrinks. When you earn over $92,000 dividends are taxed starting 15-29% and higher depending on your province.

If you invest in XIC.TO—a Canadian index ETF—which pays a 2.64% annual Canadian dividend, this tax bill adds up over the years. At a 20% tax rate on dividends, it shrinks your return by over 0.5%.

If we expect the Canadian index with dollar cost averaging to return 6% after inflation over a long time frame, our net return after taxes is 5.5%. Investing $500 a month for 30 years, the compounded tax bill cost us $45,000. The leftover $455,000 investment account will generate dividend income of $12,000 a year (at 2.64%). Chances are you will pay zero tax on that income, maybe even saving a couple bucks in other taxes.

It can take a substantial amount of time offsetting taxes on RRSP, pension, CPP/OAS, and other taxed income in retirement to match this compounded tax loss. Especially when only half the capital gains are taxed.

In the same scenario ($500 invest per month for 30 years), the capital gains portion of our investment will be $320,000 of the $500,000 total investment. This means every withdrawal will consist of 64% taxable capital gains. If you withdraw 2.64% a year ($13,200), your capital gain portion will be $8,450. You would pay around $1,000 in taxes on that capital gain at the lowest tax bracket, netting you $12,200.

You basically end up at the same net income, but you can offset capital gains tax with capital losses! These losses can be carried forward indefinitely.

Canadian Dividend Summary

Earning under $46,000: Invest via XIC.TO instead of HXT.TO for your Canadian portion of the Cash/Margin account. It can work in your favour, especially in retirement. In fact, it's almost like creating a second TFSA!

Earning $46,000 to $92,000: Either XIC.TO or HXT.TO works, it doesn't really matter. Tax-wise it's pretty much a wash over the long term. You pay some tax on dividends during working years which drops your overall return, but you are likely to pay no tax on dividends in retirement while offsetting taxes on other retirement income.

Earning more than $92,000: You are probably better off to stick with HXT.TO for your Canadian portion. You earn higher rates of return during your working years and still pay relatively low capital gains tax on withdrawals in retirement.

For the international and bond investments, stick to Horizons swap-based ETFs to defer your tax bill until retirement. Capital gains are taxed at much lower rates than interest and foreign income. This works best regardless of your income level.

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Taxes on Investment Income

Canada, like most progressive countries, offers great tax incentives for savers. TFSAs, RRSPs, and tax advantaged income from investments are designed to encourage investment and saving. Pity most Canadians save almost nothing because they're obsessed with vinyl siding and Caesarstone.

Common Types of Investment Income

Canadian Dividends: Great Tax Advantages

Canadian dividends are distributions from Canadian-based companies which are paid to you after the company has paid corporate taxes on that income. Since it's already been taxed at the corporate level, the government adjusts the tax rate lower for us when profits are distributed.

In most provinces, if you earn less income than the first tax bracket increase ($46,000 now), you actually pay negative tax rates. The CRA won't literally cut you a check, but you can offset taxes on other income—CPP, pension income, capital gains, or RRSP income for example.

Dividends are generally paid regularly (monthly, quarterly, or annually) so you must pay taxes on them the entire time you hold the investment. This somewhat reduces your overall return on investment, particularly if you live in certain provinces and have a high income. Even if you reinvest your dividends (DRIP), you still pay taxes on them!

Capital Gains: Great Tax Advantages

Capital gains are the underlying increases in value of your investments. If you bought an ETF unit for $30 and it climbed to $50, you have a $20 capital gain on that unit. You only pay taxes when you sell your investment (realize the gain). There's a 50% inclusion rate, so you only claim half your total capital gain ($10 per unit in this case).

If you don't sell your units, you can defer your taxes for a very long time. This is great for retirement because you can realize the capital gains when your income is low.

Return of Capital: Great Tax Advantages

Return of capital (RoC) is another form of distribution that's common in REITs and some tax advantaged mutual funds. It is a fancy term for getting your own money back.

You don't get taxed on return of capital distributions at all because you purchased the investment with "after-tax" money.

Return of capital distributions decrease the cost-base of your investment. If you bought a REIT unit for $30 and received a $5 RoC distribution, your unit cost for tax purposes drops to $25.

RoC acts like a deferred capital gain and is eventually taxed like capital gains. If your cost-base drops down to $0 and you receive more RoC distributions, just half of the distribution is taxed (same as a capital gain).

Foreign Dividends: No Tax Advantage

Foreign dividends are distributions received from companies not based in Canada. They are taxed at your full tax rates like employment income, RRSP income, CPP/OAS income, etc. However, they can carry a slight advantage because you can deduct the tax paid to the foreign government from your own taxes when you hold these investments in a Cash/Margin Account.

You are generally limited to claiming back foreign taxes paid up to 15% of the income received. If the foreign withholding tax rate was higher than 15%, you may be able to claim the balance as an "Other deduction" under S. 20(12) of the Income Tax Act.

For example, a U.S. stock paying $1 in dividends will have 15% of the dividend withheld as foreign tax paid, so you only receive 85 cents in your account. While you report the full $1 as taxable income, you can deduct the 15 cents you paid in foreign tax from your tax bill. It's not really a tax advantage, but it does prevent double taxation at the personal level.

Side note: U.S. taxes are not withheld on investments in RRSP accounts.

Interest Income: No Tax Advantage

Interest income are distributions received from interest bearing investments: typically bonds, money-market loans, or GICs. You pay taxes at your full marginal tax rate on all interest income as you receive the money. Re-invested interest income is still taxed.

Other Income: No Tax Advantage

Other income is typically paid by REITs and some ETFs as part of their regular distributions. It can be a mixture of interest income and other gains that the corporation or underlying holdings have not already paid taxes on. Other income is fully taxed at your marginal rate.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.