Should you pay attention to withholding taxes on dividends? What about about capital gains vs dividend income? Should tax considerations trump asset allocation and your risk tolerance level? I get many questions with respect to taxes and ETFs. I will suggest that you do not let taxation and withholding taxes on US and International dividends drive the bus.
Keep in mind that I am not a tax expert. When in doubt have a chat with your accountant or Certified Financial Planner. I form my opinion based on the study of asset allocation models. And I’ll also largely base the opinion after reading what the qualified experts have to say. I also make it a hobby to pester several portfolio managers and investment firms on a regular basis.
Should we worry about what goes where?
Taxes and ETFs and that TFSA question. A reader and friend recently asked if he should build the TFSA in the most tax-efficient manner? After all, in a TFSA we lose the withholding taxes on US and International dividends. There is often more dividend tax efficiency in taxable accounts thanks to tax credits. The most efficient account type for US stocks and US ETFs in a US dollar RRSP account.
Does that mean we should only hold our US equities in our RRSP account?
Justin Bender of the Canadian Portfolio Manager blog constructed a wonderful post on the most tax efficient ETF Portfolio. Here’s how that tax efficient portfolio looked in the end.
Of course this is ridiculous as Justin would point out. Perhaps even shading the portfolio to any great degree does not make sense as well.
Don’t let taxation drive the asset allocation bus.
In the above example the tax considerations determine the asset allocation. That in turn will determine the risk level and the ‘expected’ returns for each account type. You might get tax efficiency but no total returns in your taxable account. US stocks might tank and you get negative returns for an extended period in your RRSP account. That TFSA account has a Canadian home bias that so many advisors and financial planners would deplore. We still need those Canadian and US and International equities to ‘protect’ each other.
Of course the above portfolio example does not take into account the more important retirement funding scheme. aka the financial plan. We may need the TFSA account to work just as hard as the RRSP account. On the flip side, the financial plan may call for a quicker draw down of RRSP assets so that the retiree can delay CPP and OAS. That would require an RRSP portfolio at a lower risk level. Those are greater considerations.
It’s tax free after paying withholding taxes.
And after tax returns in ETFs can get tricky. Here’s a great article in Advisor’s Edge.
Foreign withholding tax: Is the credit always worth it?
From that post an in regards to a US generous dividend holding …
Compared to a non-registered account, the TFSA provides the higher after-tax dividend despite being ineligible for the foreign tax credit because no Canadian tax applies. This makes Lucille’s tax rate 15% instead of 40% on this dividend.
Tax free being tax free after any withholding taxes have been applied is a powerful force. If a tax free account is part of the long term retirement funding plan it needs the growth potential and diversification offered by US and International stocks. Period. You can apply the same logic to RRSP/RRIF and taxable and RESP accounts.
Should we ignore taxation?
Well of course not. Your financial plan will determine what buckets to build and at what risk level. Then I’d suggest that we let the asset allocation drive the bus. We then employ the most tax efficient strategy. And make no mistake that can be important.
For example, for your RRSP account you might open a US dollar account for your US stocks or ETFs. With respect to your taxable accounts you can discover if Canadian dividends are more efficient compared to capital gains. If you’re a fan of the big juicy Canadian dividends you might use more of them in that taxable environment.
For the US component of your taxable account you may choose stocks or funds with smaller dividends but equal or greater total return potential.
Tax efficient total return ETFs.
And when we consider taxes and ETFs we might look to Horizons for their tax efficient total return ETFs. Those funds are swap-based and do not pay dividends. Heck, they even have ‘bond funds’ that don’t pay dividends. And the tracking errors on these funds is essentially zero.
And sure you might choose that more tax efficient BMO discount bond ETF for taxable accounts. But that may not be the best way to manage equity risk. I’d suggest managing risk is more important that some minor (potential) tax efficiencies.
There are more tax moves that can be applied once you’ve decided upon the greater asset allocation requirements. Investors and advisors, please fire away in the comment section.
Could we slant or shade the portfolio slightly with respect to Canadian, US and International equities. I’d guess so if the moves are not too excessive. But in the end there might not be any total return after tax advantage. Greater total returns can trump lesser tax rates.
Weekend Reads and Podcasts.
A few of us blogger types were more than happy to chip in for Jonathan Chevreau’s most recent post for MoneySense. Jon is writing a series of three articles on the Canadian mutual fund landscape. Please have a read of Mutual fund fees and the future of investment advice. I see that I was not in a good ‘mutual fund mood’ when I offered up, ha.
Savvynewcanadians offers What is an RESP? Enoch also suggests that Justwealth is the Robo choice in Canada for the RESP program. I don’t disagree.
I had also recently reported on the Justwealth target date funds for RESP.
Rob at passivecanadianincome writes on his first ETF holding. Rob likes to select his own Canadian dividend stocks. He now owns one ETF covering a world of stocks.
Here’s myownadvisor’s Weekend Reads post that can do a lot of the heavy lifting for great reads and podcasts.
Genymoney looks at the very interesting concept known as Wealthica.
The rationalreminder podcast discusses death and marriage (insert joke here) and the legal side of financial planning.
Ben Carlson at A Wealth of Common Sense looks at where the magic happens in the stock market. Ben looks at Apple, one of my two US growth stock picks. Apple has doubled in share price over the last year. The magic here is that revenues and earnings did not necessarily blossom, just the share price. For any new purchases investors are now paying double for ownership of the current profits.
No problem there for me. I’m good at making those homemade Apple dividends given my semi retirement status. Apple has already funded a few trips.
Larry Bates of Beat The Bank offers some thoughts on investing in 2020 and beyond.
Have a great weekend. Don’t forget to follow Cut The Crap Investing. And we’ll see you in the comment section. Please offer your thoughts on taxes and ETFs.
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Thanks for reading this post covering taxes and ETFs
Dale
Some excellent material for a discussion Dale. I found myself bouncing back and forth with the introduction of each new section.
In the end, total after tax dollars at a given risk level is what we should all be targeting. This of course is challenging with foreign tax, different tax rates on distribution types, government or other pensions, unknown future returns and uncertain future tax rates / policy. Not to mention different metrics to measure risk (e.g., drawn down risk, shortfall risk, volatility)
For me, where it makes sense to optimize for the account I do. I hold as much of my foreign exposure in my RRSP as I can and the remainder in my TFSA along with my Canadian holdings. I don’t fill my TFSA with Canadian exposure for the sake of avoiding tax because that increases the risk level (resulting in a lower after tax return for the risk level).
If as I approach retirement I find the accounts are out of line with my draw down strategy for tax purposes I can rebalance through contributions or investments. I find it’s often important to focus on what we can control, which for now is the foreign withholding tax, and worry about the rest later, as more information is available.
It gets complicated doesn’t it? Or, at least it did for me with trying to mix and balance my need for income vs portfolio stability from my cash, TFSA, and 2 RIF accounts.
Since retiring I followed the premise of having most of my Canadian dividend ETF’s in my cash account (also contains 40% preferred shares ETF) and some in my TFSA whereas my RIF accounts contained my US and International dividend ETF’s (60%) as well as a 40% allocation to FI bond ETF’s.
So far so good. After selling some of my XDG and buying $50K of BPY I am done tinkering for 2020.
Thank you for mentioning Wealthica ! 👍
My pleasure Martin, I will be having a closer look as well.
All the best, thanks for stopping by.
Dale