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.
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.
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.
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
International Equity ETFs
Global Equity and All-in-One ETFs
*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.
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.