A Super Tax Efficient Index ETF Portfolio for your Non-Registered Account

For regular followers of MDJ, you will know that I’m a fan of both index and dividend investing.  I use index investing for long-term, hands off portfolios, such as my spouses RRSP and LIRA (from her commuted defined benefit pension), and my children’s education fund.

Related:  6 Ways to Index Your Portfolio

I use the dividend growth investing strategy to produce growing passive income to one day achieve financial independence – ideally sooner rather than later.  However, one issue with long-term dividend investing in non-registered (ie. taxable) accounts is the tax leakage.  In other words, all those juicy dividends being generated are also subject to tax.

The Portfolio Leak

While the tax on a Canadian publicly traded company dividend is fairly tax efficient (due to the dividend tax credit), it still creates a drag on the portfolio.  Since a stock market index is a collection of the largest companies in any particular country (or sector) – large blue chip companies generally pay a dividend, thus index ETFs generally have a dividend yield associated with them.  To add to this, international dividends and bond interest are taxed like income, which can be high for some and definitely taxed higher than Canadian dividends.

The dividend yield on an index ETF/fund may be smaller than a dedicated dividend portfolio, but it’s still a tax drag that can add up over the long term while in a taxable account.  Especially so for high-income employees who are already in a high tax bracket.

To solve this tax issue, the most efficient choice is to keep all of your money in tax-sheltered accounts (ie. RRSP/TFSA etc).  However, what if you’ve maxed out all of those accounts and have savings left over that can be invested in the market?  That’s where tax-efficient ETFs come into play.

The Solution for Taxable Accounts

Horizons has created index ETFs that pay 0% in distributions or dividends. Instead, you will only be taxed with capital gains tax when you sell down the road. The dividends are still there but used to compound instead of being paid out.

This is attractive in that the ETFs can grow tax-free while you are accumulating and earning a salary.  Then, when it comes time for retirement and theoretically lower income, you can sell off small portions of your portfolio and only pay capital gains tax.

Next question is, how exactly are they able to do this?  This involves a complicated financial instrument called swaps.  Essentially, Horizons uses National Bank as a counter-party to deliver the returns of the index.  So if the TSX 60 (Canadian large cap index) returns 5%, then National Bank is responsible for paying Horizons 5%.  Sounds risky?  It’s actually not as risky as the word “swap” sounds.  Canadian Couch Potato explains that if National Bank defaults on their payment to Horizons, then it’s only the gain that is at risk, not the original invested amount.  Also, if National Bank defaults, we likely have bigger problems in the Canadian stock market, thus no returns would be owed to Horizons.

The Leak-Free Portfolio

A basic globally diversified indexed portfolio typically involves the following parts:

  • Canadian Index
  • US Index
  • International Index
  • Bond Index

Up until recently, Horizons ETFs was missing tax efficient international coverage but that changed with the introduction of the Horizons Intl Developed Markets Equity Index ETF with the ticker HXDM.  This ETF gives exposure to the MSCI EAFE index which covers developed markets outside North America.

With the missing piece of the puzzle, here is a globally diversified no-leak indexed portfolio from Horizons:

  • Canadian Index (TSX 60): HXT (MER: 0.07% reduced to 0.03% until Sept 2018)
  • US Index (S&P 500): HXS (MER: 0.40%)
  • International Index (MSCI EAFE):  HXDM (MER: 0.50%)
  • Canadian Bond Index: HBB (MER: 0.24%)

If you had 25% of each ETF, the total portfolio would cost about 0.30% which is not bad for a tax-efficient portfolio.  Having the option of using these ETFs adds another weapon in overall tax planning.

For ultimate efficiency, consider opening a non-registered account with a brokerage that allows you to trade ETFs commission-free.  I recently opened a non-registered account with Questrade (her TFSA and RRSP already maxed out) for this purpose.

2021 Update : Qtrade is now my preferred broker. Their fees are a bit higher than Questrade, but they offer free buying AND selling of ETFs as opposed to Questrade where only buying is free.

I've Completed My Million Dollar Journey. Let Me Guide You Through Yours!

Sign up below to get a copy of our free eBook: Can I Retire Yet?

Posted in

FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
Subscribe
Notify of

This site uses Akismet to reduce spam. Learn how your comment data is processed.

36 Comments
Inline Feedbacks
View all comments
Dennis
1 year ago

I have taken on with Questrade my first leap into ETF’s. The leak proof idea is critical.
Canadian Index (TSX 60): HXT (MER: 0.07% reduced to 0.03% until Sept 2018)
US Index (S&P 500): HXS (MER: 0.40%)
International Index (MSCI EAFE): HXDM (MER: 0.50%)
Canadian Bond Index: HBB (MER: 0.24%)
I just need to know if there is any need for me to track buys and sells to determine the ACB’s and gains or will Questrade issue me the Tslip that will make the CRA happy seeing their cost base and sold price.
If I need to take on the ACB tracking. I have to start now. Your first hand experience is important, as I could not get enough clarity talking to Questrade.

SG
2 years ago

never invested, not knowing

PC
2 years ago

can you comment on whether you support these being held in TFSA/RRSP? i’m assuming yes but want to be sure i’m not missing something. thks.

Park
2 years ago

I’m not as sure that these are ideal investments for taxable accounts. The CRA is losing tax revenue with these products.

Income trusts (2006) and corporate class mutual funds (2016) were costing the CRA tax revenue, and they no longer exist.

One must consider the possibility that the government will decide that these derivative based products should no longer exist also. In this case, the derivatives are swaps.

In 2013, there were funds using derivatives (forwards) to improve tax efficiency, and once again, the CRA was losing tax revenue. The government decided to end these funds.

http://canadianfinancialdiy.blogspot.ca/2013/03/budget-shoots-down-tax-advantaged-swap.html
http://www.marketwired.com/press-release/blackrock-canada-announces-changes-to-forward-using-isharesr-etfs-1831816.htm

Anyone investing in these products must consider the possibility that they will end, and that they will pay cap gains tax on all their capital gains.

Park
2 years ago

I’m not as sure that these are ideal investments for taxable accounts. The CRA is losing tax revenue with these products.

Income trusts (2006) and corporate class mutual funds (2016) were costing the CRA tax revenue, and they no longer exist.

One must consider the possibility that the government will decide that these derivative based products should no longer exist also. In this case, the derivatives are swaps.

In 2013, there were funds using derivatives (forwards) to improve tax efficiency, and once again, the CRA was losing tax revenue. The government decided to end these funds.

http://canadianfinancialdiy.blogspot.ca/2013/03/budget-shoots-down-tax-advantaged-swap.html
http://www.marketwired.com/press-release/blackrock-canada-announces-changes-to-forward-using-isharesr-etfs-1831816.htm

Anyone investing in these products must consider the possibility that they will end, and that they will pay cap gains tax on all their capital gains.

luc
2 years ago

so essentially you are deferring tax like an RRSP, earning interest off the deferred tax with the added benefit of having the ‘dividend’ being taxed as a capital gain in the future, while in a lower tax bracket?

Jared
3 years ago

So if I understand this correctly, HXT would be the perfect option for the Smith Maneuver?

jamie
3 years ago

FT, interesting article, thanks. Any specific thoughts on holding these type of ETFs in non-regd corporate accounts?