With stocks and ETFs, don’t be myopic about yield

I was wondering about two of the exchange-traded funds you recommended in last week’s column. The Vanguard Growth ETF Portfolio (VGRO) and BMO Growth ETF (ZGRO) yield just 2 per cent and 2.5 per cent, respectively. That seems hardly worth the investment in view of the fact that inflation averages 3 per cent. Am I missing something in my understanding?

You’re missing a couple of things, actually.

First, Canada’s inflation rate is substantially less than 3 per cent currently. For October, the consumer price index rose just 0.7 per cent on a year-over-year basis, Statistics Canada reported this week. Over the past five years, the annual inflation rate averaged a little more than 2 per cent.

Second, and more to the point of your question, the dividend yield of a stock – or an ETF that holds a basket of stocks – is just one component of the return. Over the long run, capital growth usually makes an even greater contribution. For example, the S&P 500 index currently yields less than 2 per cent. But over the past 10 years, the S&P 500 has produced an annualized total return – including dividends – of about 13 per cent, driven by rising prices of stocks in the index.

It’s a common mistake, particularly with new investors, to evaluate a stock or ETF based solely on its dividend yield. Stocks with puny yields can produce outsized gains if they’re reinvesting their cash internally at high rates of return – think of tech stocks such as Amazon.com or Facebook that pay no dividends at all. And stocks with high yields can deliver disappointing results. In some cases, an exceptionally high yield can be a danger sign that may portend a dividend cut.

In my model Yield Hog Dividend Growth Portfolio, I try to get the best of both worlds by identifying stocks with above-average yields that will also produce dividend and capital growth over the long run.

I have some questions about the U.S.-listed iShares Core Dividend Growth ETF (DGRO) in your model Yield Hog Dividend Growth Portfolio. Is it an eligible investment for registered retirement savings plans, and will it be subject to any U.S. withholding tax if held in an RRSP?

Yes, DGRO is eligible for RRSPs. No, under the Canada-U.S. tax treaty, dividends from U.S.-listed ETFs such as DGRO are not subject to U.S. withholding tax as long as the units are held in an RRSP or other registered retirement account. DGRO’s dividends will, however, be subject to a 15-per-cent withholding tax if the units are held in a tax-free savings account, registered education savings plan or non-registered account. The same withholding tax rules apply when investing in U.S.-listed stocks directly.

Keep in mind, however, that if you buy a Canadian-listed ETF that holds U.S. stocks, the 15-per-cent withholding tax will apply regardless of the account type in which you hold the ETF. If you’re investing in a non-registered account, you may be able to claim the tax withheld as a foreign tax credit on your Canadian return. However, this is not an option for registered accounts.

Want to read more? BlackRock, the company behind iShares ETFs, has a handy reference guide to withholding tax on its website .

Is it possible to transfer stocks that I have in my registered retirement income fund to my tax-free savings account, provided I have room in my TFSA?

Yes, you can move shares in-kind from an RRIF to a TFSA, but there will be tax consequences.

The transfer involves two steps. The first step is withdrawing the shares from your RRIF. Because RRIF withdrawals are taxable, the fair market value of the shares will be added to your income for the year and taxed when you file your return. (Also be aware that, if the value of your RRIF withdrawal exceeds the federal government’s annual minimum percentage withdrawal based on your age, your broker will apply withholding tax. The tax withheld will then be credited toward the future tax you have to pay.)

The second step is contributing the shares in-kind to your TFSA. Your broker will do the RRIF withdrawal and TFSA contribution as if it’s one seamless transaction, but that won’t get around the tax on the withdrawal.

You did not indicate why you want to transfer shares from your RRIF to a TFSA. This could be a prudent strategy if, for example, you have low income in a particular year. Getting assets out of your RRIF at a lower marginal tax rate and contributing the assets to your TFSA will allow you to continue to benefit from tax-free growth.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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