Smith Manoeuvre: Is a Dividend Portfolio Required?

I get asked occasionally about investment options in the Smith Manoeuvre. Do you need to invest in a dividend strategy? What about ETFs? Can you use a trend portfolio?

The investment portfolio is an important component of the Smith Manoeuvre strategy. In order to have the HELOC loan interest qualify as a tax deductible expense (the whole point of the Smith Manoeuvre), you need a dedicated non-registered investment account where your borrowed money is invested.

This money should be carefully tracked at every step of the way to ensure full tax compliance. This means direct transfers from your HELOC to your Smith Manoeuvre investment account. Dividends from the Smith Manoeuvre investment account go to your Smith Manoeuvre chequing account. Both sides of your HELOC get paid from your Smith Manoeuvre chequing account.

These accounts are only for the Smith Manoeuvre process. No outside money, no mixing accounts to save a couple bucks on any account fees, and no taking money from your HELOC to pay for Mexico vacations or concrete countertops.

The structure is not necessarily simple, as you can see by my chart below. But the rewards are significant!

You can save thousands of dollars a year in taxes just for moving money through a few extra accounts once a month. This tax money can be used to pay off your traditional mortgage faster and boost your investment accounts.

Once you have all the accounts set up and understand the process, it should take no more than a few minutes of your time, a few times per month to complete the transactions.


SM Investment Account

All of the component accounts of the Smith Manoeuvre are necessary for the strategy to work seamlessly.

As per the CRA's definition of income, every last dollar in your Smith Manoeuvre investment account (money borrowed from Portion 2 of the HELOC) must be invested in an asset that generates one of these types of income: Canadian dividends, foreign dividends, interest income, or certain forms of business income.

It's important to understand the distributions are not required to exceed your interest expenses. It is just some income that qualifies for your loan interest to be tax deductible.

Capital gains (distributed or embedded) or return of capital distributions do not count!

The direct application of income generating assets from your borrowed money is why your Smith Manoeuvre investment account must be kept separate from any other non-registered investments.

ETF Investing in your SM Account

It is certainly possible to invest with ETFs in your Smith Manoeuvre investment account and be tax deductible and successful.

As long as the ETFs pay dividends or interest, whether they are foreign or Canadian-based, they are likely to meet the standard for tax deductibility on your HELOC loan.

Although there are differing opinions on this, I would avoid most funds which are advertised as being tax efficient. This includes swap-based ETFs, T-series funds, or corporate class funds.

Compared with direct stock investing, ETFs may simplify the investing process and decision making, but they are likely to add some complication your tax situation. They are also likely to be less tax efficient compared with other options.

The problem with the vast majority of ETFs is that they distribute several different forms of income each year within each distribution.

Some forms of income are less desirable because they are taxed at higher rate, such as foreign dividends and interest. These are commonly found in international equity ETFs and bond ETFs.

Distributed return of capital, common with ETFs and REITs, causes you more work at tax time and can reduce the tax deductibility of your SM HELOC over time if not adjusted correctly.

Most ETFs and mutual funds are likely to be less tax efficient than investing directly in Canadian-listed stocks. That doesn't mean you should avoid all ETFs, but it does mean you should take this into consideration when planning your investment strategy.

If you invest in ETFs, you should prefer ETFs which are low cost, highly liquid, and pay a low distribution yield.

Avoid bond ETFs where the investment return is mainly in the form of distributions instead of unit price gains.

Investing with ETFs means you can employ a large variety of the strategies I talk about on this blog. That includes buy-and-hold investing with Vanguard Portfolio ETFs and my TADM strategy.

Stock Investing in your SM Account

Investing directly in publicly-listed Canadian corporations is a popular strategy for Smith Manoeuvre investors.

Directly holding Canadian stocks means you can design a very tax efficient portfolio that is very likely to meet the requirements for interest deductibility set out by the CRA.

As long as the company stock you invest in pays a tiny dividend or even states intent to pay a dividend at some point in the future, your SM HELOC interest will be tax deductible.

Directly investing in individual corporations also helps you avoid the potential distribution mix nonsense of many ETFs and REITs. Individual corporations distribute dividends, that's it.

Canadian-listed companies distribute dividends which are eligible for the dividend tax credit. This can significantly lower your tax bill on the distributed investment income, keeping your account tax efficient.

There are countless strategies you can use to invest with individual stocks. Trend investing, value investing, dividend growth, high yield dividend, Buffet moats, large cap equal weight, etc.

The keys to successful individual stock investing include: adequate diversification, systematic buying and selling, and cutting losses on positions when needed.

If your strategy kicks you out of a stock position, don't hold cash in your SM account. Instead, put the money in a more tax friendly bond fund like the FirstAsset 1-5 Year Laddered Strip Bond ETF (BXF.TO) or the BMO Discount Bond ETF (ZDB.TO).

Of the strategies I mentioned, naturally I'm a fan of trend investing. It's generally easy to track, requires little guesswork or "guesstimating", and can result in a pretty smooth ride.


Let's look at a portfolio of ten currently popular Canadian stocks which pay dividends: Royal Bank, Manulife, Power Financial, Enbridge, ATCO, Canadian National Railway, Loblaws, Telus, Brookfield Asset Management, and Fairfax Financial.

Since 2001, if you would have run a 10-month simple moving average screen on these stocks, trading no more than once a month, you would have seen fantastic results.

The portfolio would have a maximum drawdown of 11 percent and a compound return over 10 percent per year.

To achieve that same level of risk in a Canadian Couch Potato portfolio, you would have invested in the "Conservative" model. That's just 30 percent in the stock index and 70 percent in Canadian bonds.

Your compounded return would have been around 5.5 percent per year with that approach. Still decent, but certainly not great.

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High Interest Savings Accounts

While writing my blog post on GICs last week, I also took a look at some of the high interest savings accounts out in the market today.

In the past, I have ridiculed high interest savings accounts, so most readers correctly got the impression that I think you should avoid them.

In a broad sense, that is still true. Most of the savings accounts in the Canadian market today are so utterly pathetic you may as well save yourself the hassle and keep money in a free chequing account where you do all your daily banking.

Moose Tip: Some good options for free chequing accounts include Tangerine and Simplii. There is no good reason to be with a big bank that charges you a monthly fee for your chequing account!

Thanks to the rising interest rate environment, a few bright spots have opened up in the savings account market over the past few months.

Right now, EQ Bank, a second-tier federal bank, is paying a whopping 2.3% interest on their savings account. Oaken Financial, another second-tier federal bank, is paying a solid 1.5% interest on their savings account. While Tangerine and Simplii are paying 1.25%.

All of these banks are CDIC insured, so provided you don't have more than $100,000 in a savings account with each bank, your money should be very safe. I go into more details on CDIC protection in my GIC post, so I won't bore you with those here.

Savings accounts should be used pretty sparingly for most people. But it varies depending on your stage in life. There are some reasonable uses for savings accounts.

Savings Accounts for Accumulators

Accumulators are working hard, earning as much as they can, maintaining a high savings rate, and investing aggressively. Savings accounts should not really be in the financial picture most of the time. Even for emergencies!

An accumulator should conduct their daily banking in their free chequing account while maintaining a small balance there. I personally don't see any benefit with keeping more than one month's worth of expenses in your chequing account at the low points.

For most people this means their chequing account will fluctuate from around $2,000 on the bottom end to maybe $10,000 on the top end. Your numbers depend on your pay schedule, your spending rate, when your bills are due, how often you contribute to your investment accounts, if you share a bank account with your partner, and so on.

The key for an accumulator is moving as much money as fast as possible from the chequing account (where income is deposited and bills are paid) into an investment account where it can be put to work.

In most investment markets, the more you invest as early as possible the better off you will be.

For emergencies you should have an already-approved personal line of credit waiting for you at the bank.

Your personal line of credit should have a credit limit equal to six months of expenses at the high side. However, you should not touch this available credit at all unless it is a true emergency.

True emergencies include income emergencies (job loss, severe illness, etc.) and some spending emergencies (unforeseen house or vehicle repair, death in the family, supporting a loved one who is in an income emergency, etc.).

If you have to use it, your aim should be to pay your line of credit off as fast as possible, even if that means setting aside new investment contributions for a few months.

The one scenario where a savings account may be worthwhile for an individual in the accumulation stage is when you are saving money for a specific large expense (well over $10,000) which is coming in the near future. This might be a vehicle, home renovation, home purchase, other something of that nature.

Savings Accounts for Retirees

When you are at the stage in life where you primarily live off your investment holdings, you need to become a lot more careful about how you manage your finances.

The majority of your money should be in your investment accounts invested primarily for growth. Alternatively, you could invest in a timing strategy for downside protection. Better still, consider two strategies to diversify your investment returns.

Depending on your personal situation, a good portion of your spending needs may be covered for through regular income. This can include CPP payments, OAS benefits, dividend income (from stocks or stock ETFs), interest income (from bond ETFs), or even some part-time employment or business income.

To keep things easier to manage with fewer manual electronic transfers, once you are retired you can set up your non-registered investment account so dividend income comes straight into your chequing account. Most dividend paying ETFs pay out quarterly or semi-annually while most bond ETFs pay out monthly or quarterly.

It is important to have some cash set aside for daily living expenses which are not covered by your regular income. It doesn't make sense to pull money out of your portfolio every month, triggering capital gains and trading costs while taking up your valuable time.

Instead, use a systematic method to pull money out of your investment account on an intermittent basis. Once or twice a year is good.

You should try realize gains or withdraw money from registered accounts in the most tax efficient method. The exact combination of RRSP withdrawals, TFSA withdrawals, and capital gains in your non-registered accounts will depend on your personal situation at that time.

If you have a high spending year, your spending may be tilted towards TFSA withdrawals and realized capital gains. In a low spending year RRSP withdrawals may form the majority of your investment income.

Since the withdrawals are not made frequently, they can be quite substantial in value. It would not be uncommon to need tens of thousands of dollars a year in these forms of income.

These large lump-sums should not be put in your chequing account. Chequing accounts pay no interest (typically), so your money will actually erode in value thanks to inflation costs.

Instead, set up a high interest savings account to hold this money. Shop around for an account that offers a higher interest rate along with free monthly money transfers such as Interac e-Transfer or electronic funds transfer to your chequing account.

Keeping this money in a high interest savings account will ensure your money generates moderate interest income while you are waiting to spend it.

Use of savings accounts in retirement can be instead of, or alongside a GIC Ladder. Just keep your overall cash balance in mind. Cash might be comforting, but too much cash is a problem.

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