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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