The Real MER on ETFs – Foreign Withholding Taxes on ETFs
I’ve written a lot about index investing as one of the best strategies for beginner and experienced investors alike. It’s a strategy that I follow with a large portion of my portfolio to get ex-Canada (outside Canada) diversification (I use dividend investing for my Canadian exposure). Not only do I use this strategy in my own portfolio, but also our family portfolios are also indexed.
For my wife, we have her RRSP and LIRA in either iShares XAW or the components that make up XAW (XUU, XEF, XEC). For my kids, I have a family RESP setup that uses the TD E-series family of low-cost index mutual funds.
Related: Here are 6 ways to index your portfolio
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Why Index ETF Investing
Needless to say, we have a significant portion of our wealth tied to this strategy. Here are some of the reasons why I recommend Index ETF investing:
- Is a great way to get international diversification – Canadian’s tend to have too much of their investments tied to Canada (I’m also guilty of this). I tend to use iShares XAW for my international diversification held in a registered account (RRSP/TFSA).
- Can lower your portfolio’s management expense ratio (MER) when compared to mutual funds – Even if you have lowered your portfolio MER by choosing index mutual funds, you can essentially cut your MER in half by going with ETFs. Just reducing your MER by a little can have drastic results over the long term.
- Will outperform the majority of mutual funds out there today – The MER matters and likely the reason why active mutual funds do not beat the index. Say the index returns 7% in a year. A 2.5% MER active mutual would need to return at least 9.5% just to match the index. My money is on the index.
- Can be easy and hands off – Perhaps the biggest benefit of index investing is that it’s super easy. When I didn’t think that index investing could get any easier, the big ETF players have released all-in-one ETFs that automatically rebalance. So now you don’t even need to rebalance your portfolio.
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What is Foreign Withholding Tax?
When you buy U.S dividend stocks in a taxable account, you may notice that the dividend will have 15% withheld (providing you filled out a W-8BEN, otherwise 30%). Although you see money coming out of your account, it’s used to offset your taxes owing on that dividend when you file your tax return (taxed like interest). So the withholding tax is not lost.
What about US dividend stocks within an RRSP? For RRSPs, there is a tax agreement between Canada and the US that eliminates the 15% withholding tax on US dividends. While this is great, the agreement does not extend to TFSAs so US dividends within a TFSA will face a non-recoverable 15% tax.
Foreign Withholding Tax on ETFs?
So what about US and international ETFs? This is where it gets tricky!
While holding US stocks directly in an RRSP gets preferential tax treatment, did you know that an ETF that holds underlying ETFs does not qualify for the tax exemption? So essentially with the additional embedded tax, you are paying a higher MER than you think!
International equities would be subject to withholding tax in an RRSP/TFSA, and gets even larger if the international ETF holds underlying ETFs. The bright side is that the more popular international equity ETFs like iShares XEF and Vanguard VIU hold individual stocks, which results in only one level of withholding tax.
An Example
For example, one of my favorite ways to get US exposure in my RRSP is through the iShares XUU because of the diversification and because of the extremely low MER of 0.07%.
However, since XUU holds underlying ETFs, it would face foreign withholding tax in the tune of 0.32%. This results in a total MER of 0.39% when held in an RRSP/TFSA.
As another example, one of my favorite international equity ETFs within my RRSP is owning iShares XEF. This ETF has a MER of 0.22%, but since it holds stocks directly (and not other ETFs), the resulting withholding tax is 0.30%. When holding in an RRSP/TFSA, the resulting MER is 0.52%.
Calculating Withholding Tax on ETFs
Justin Bender, from Canadian Portfolio Manager blog, does a great job explaining ETF withholding tax and has even created a nifty calculator that really helps simplify the concept.
Without getting into the details of how to calculate the withholding tax, let’s get into the good stuff and show the total MER including withholding tax in each account type of some popular ETFs.
U.S Equity ETFs
| ETF | TFSA | RRSP | Non-Reg |
| XUU (CAD) | 0.39% | 0.39% | 0.07% |
| VUN (CAD) | 0.46% | 0.46% | 0.16% |
| ITOT (USD) | 0.35% | 0.03% | 0.03% |
| VTI (USD) | 0.34% | 0.04% | 0.04% |
International Equity ETFs
| ETF | TFSA | RRSP | Non-Reg |
| XEF (CAD) | 0.52% | 0.52% | 0.22% |
| VIU (CAD) | 0.54% | 0.54% | 0.23% |
| IEFA (USD) | 0.84% | 0.36% | 0.36% |
Global Equity and All-in-One ETFs
| ETF | TFSA | RRSP | Non-Reg |
| XAW (CAD) | 0.58% | 0.58% | 0.26% |
| VXC (CAD) | 0.75% | 0.75% | 0.38% |
| VGRO (CAD) | 0.46% | 0.46% | 0.27% |
| XGRO (CAD) | 0.41% | 0.41% | 0.22% |
| VBAL (CAD) | 0.44% | 0.44% | 0.27% |
| XBAL (CAD) | 0.36% | 0.36% | 0.22% |
*Note that dividends received from non-Canadian companies in non-reg accounts are taxed like interest (ie. added to your marginal tax rate). Also note the cost of foreign currency exchange from CAD to USD.
Final Thoughts
As you can see from the table above, withholding taxes can really add to the overall MER of your portfolio – especially in registered accounts. No longer is the advertised MER of XUU (covers US market) 0.07%, but after withholding taxes in an RRSP, it’s 0.39%!
However, you can further reduce your MER if you are willing to transfer your CAD to USD, and buying the US versions of the ETF – like VTI instead of XUU. But note that there is an added cost of doing foreign currency exchange – but can also be minimized using Norbert’s Gambit.
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thank you for this information. I have USD and maxed out rrsp. So I have no option but to add to tfsa . I was planning to buy VTI to avoid currency conversion. So the dividend gets taxed at 15 % but the MER does not change in this case ? How is MER in this case?
Thank you for this information.
Where/How do I find if the ETF has an underlying ETF’s that would affect the total MER.
Im looking at VFV
Hello,
I was just taking a look at my questrade account history for my rrsp account. I currently hold XUU in the account. In comparing my actual dividend payouts to the ones posted on ishares website i don’t see any difference, that is i do not see any deductions for the withholding tax. Am i over simplifying this check? Is there a better way to see how much i’ve been paying / losing in withholding taxes?
Thank you
Beginner here, go easy on me.
Why is the MER lower for non-registered accounts lower? Is it just because those taxes come out separately at tax time? And if so, how does that effect the net gains, is it any different?
Thanks for any help.
Hi Calum, it has to do with tax treaties that Canada has with other countries. Also, the withholding taxes mentioned here are not paid out of pocket during tax time, they are taken out of returns.
Are the etf trailing returns on morningstar.ca net of fwt? Thks.
It would be challenging to calculate returns net of FWT due to different percentages for different accounts. I would assume no.
After reading this article and realizing that ETFs have additional cost in FWT I started looking into the TD eSeries if they have FWT as well. I was looking at the RRSP account in the comparison between the ETFs and the TD Index funds. Based on your table above for RRSP accounts the VGRO is 0.46% and XGRO is 0.41% respectively. These percentages come in line with the MERs for the TD index funds (0.35% for TDB902 and 0.51% for TDB911). However, the CCP in this article https://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/ states that the TD funds real expense is 0.65% and 0.84% for TDB902 and TDB911 respectively. This would make an average MER of 58% for asset allocation of 25% for each of CND, US, Intl equities and bonds, which is still more expansive than the ETFs. Are my assumptions correct? Please let me know. Thanks!
Hi Strela, yes you are correct. TD funds would have FWT added on top of the stated MERs.
Am I reading the holding details correctly in this situation?
iShares XUS/XUU is about 78% IVV
Vanguard VFV on the surface doesn’t show that it is primarily holding an underlying US listed ETF.
If my understanding is correct, it is obviously much more efficient to hold VFV in a registered account.
It seems to read similarly for Vanguard’s other international etf’s as well. VE etc.
Thanks
Am I in fact
Hi Garth, check out today’s post on USD ETFs in your RRSP:
https://milliondollarjourney.com/building-a-simple-low-cost-indexed-etf-portfolio-in-usd.htm
Thanks for that.
1. Just an update on VTI, Vanguard lowered the MER to .03% as of the end of April.
2. Just to clarify that these modified MERs (that take into account taxes on distributions) are dependent on the amount of distributions each period. So if the distributions change, so does the modified MER; correct?
Thanks for the update Meeko!
What are your thoughts on holding HXS in your TFSA? Wouldn’t that overcome the withholding tax obstacle?
Hi Allan,
I would hold off on Horizon’s swap-based products until CRA provides clarify on how they plan to tax them going forward.
Thanks for the go-to post. This is a biggie as you write. Folks doing everything to lower fees (a staple for success) and then many are not aware of the withholding that is significantly more than the MER and quite significant over time. This is not greatly advertised, ha.
The Robo’s mostly will face this as well. They use those fund of funds or face some currency conversion charges. A few of ’em will set up US dollar accounts for specific purposes to hold US assets. Many Canadian retirees will hold US assets to fund and hedge their US trips – Snowbirds.
Dale