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.