There's a saying to "not let the tax tail wag the dog." What it means is that investors shouldn’t prioritize tax efficiency as the dominant consideration when selecting ETFs for their portfolios. Factors like risk tolerance, investment objectives, and time horizon should always come first.
That being said, if you have all that in place, the next step is optimizing for tax efficiency. Earlier, I wrote an article on how Canadians can tax-loss harvest with various ETF pairs. Consider this article a follow-up. I'll be going over three common account types: taxable, tax-free savings accounts (TFSA), and registered retirement savings plans (RRSP), along with a discussion of what types of assets are best held in each.
The information presented above is for general purposes only and should not be construed as legal or investment advice. Ensure you always consult a tax attorney or accountant.
Taxable Accounts
Investors with assets in a taxable investment account must pay capital gains tax upon the sale of an asset. This is calculated based on the price you sold a stock at compared to your adjusted cost basis (ACB). As well, the tax must be paid on any distributions paid out, such as stock dividends or bond interest.
Here are a few ways to optimize here:
- Focus on holding eligible dividends, which are any taxable dividend paid to a resident of Canada by a Canadian corporation that is designated by that corporation to be an eligible dividend. Most large-cap dividend-paying Canadian stocks will qualify here.
- Focus on holding swap-based total return ETFs, which pay little, if any, distributions, making them extremely tax-efficient.
If you are holding foreign equity (e.g., U.S. or international listed ETFs), you may be eligible to claim a foreign tax credit of up to 15% of the withheld distributions at the source.
Avoid holding bond or real estate investment trust ETFs as their distributions are taxed as ordinary income at a higher rate.
TFSA
Capital gains in a TFSA are non-taxable, making it an excellent vehicle for high-growth investments. With a TFSA, there's no need to calculate an adjusted cost basis or worry about tax filings (unless you get caught day-trading by the CRA, that is).
There are still a few tips though:
- Remember that U.S. listed ETFs or Canadian ETFs holding U.S. assets in a "wrapper" structure are still subject to a 15% foreign withholding tax on dividends.
- Bond and REIT ETFs can be held here as their distributions will no longer be taxed.
RRSP
Contributions to an RRSP are made before tax and reduce your overall net income for the year. The RRSP is a way to defer taxes paid, so when you're in a lower income bracket at retirement, you pay less. Any withdrawals from an RRSP, later on are taxed at your ordinary income rate, but there's no capital gains tax for selling within the RRSP.
Here are a few ways to optimize here:
- Buying USD-denominated ETFs holding U.S. assets will avoid the 15% foreign withholding tax on dividends as the IRS recognizes the RRSP. If you have a way of converting CAD to USD cheaply, this can save you money.
- USD denominated ETFs holding international equity will still incur a foreign withholding tax on the underlying stocks deducted at source. There's no way of avoiding this.
- Bond and REIT ETFs can be held here as their distributions will no longer be taxed.
The following article was originally published by our partners at the Canadian ETF Market.