The cost of owning exchange-traded funds is low, but maybe not as low as you think.
Racking up a lot of brokerage commissions to buy and sell ETFs is one way to drive up your costs beyond the fees shown in the management expense ratio. Another is putting your ETF in a non-optimum type of account and paying too much tax.
Slotting an ETF into a less than ideal account can erode your returns in a subtle, but still meaningful way. If you bought an ETF that tracks a big U.S. stock index for your tax-free savings account, you could generate hidden costs that are the equivalent of an extra 0.3 per cent or so in fees.
The extra costs in this example come in the form of a 15-per-cent U.S. withholding tax (retail investors receive the net amount of dividends and don’t have to pay this tax themselves). In other types of accounts, you might be able to avoid or recover this withholding tax. But in a TFSA, that money is gone.
Withholding taxes on dividends from U.S. and international stocks are one aspect of the tax considerations in ETF investing. As with any type of investment, you also have to consider the difference in the way interest, dividends, return of capital and capital gains are taxed in Canada.
The Globe and Mail ETF Tax Primer is designed to help you find the best possible home for your ETF. Designed to be used with The Globe’s ETF Buyer’s Guide, it outlines the tax implications of investing in bond funds and Canadian, U.S. and international equity funds in a TFSA, a registered retirement savings plan or registered retirement income fund, or a taxable account.
Let’s not over-dramatize the damage done by putting an ETF in a less than ideal account from a tax point of view. “You’re not going to blow up your financial plan," said Justin Bender, a portfolio manager at PWL Capital who helped put the tax primer together. In fact, Mr. Bender wonders whether investors sometimes focus so much on avoiding withholding taxes that they fail to diversify their portfolios properly. Diversification is your top portfolio priority.
To get a sense of how much of a drag withholding taxes can be on your returns, check out the Foreign Withholding Tax Calculator available on Mr. Bender’s blog These taxes can reduce returns in TFSAs and RRSPs by as much as 0.3 per cent to 0.5 per cent for TSX-listed ETFs in the United States, global and international (i.e., everywhere but North America) categories.
This edition of the tax primer updates an earlier one that predated one of the most important ETF innovations ever – balanced ETFs, also known as asset-allocation funds. They’re basically fund-of-fund products that give you a fully diversified portfolio in a single purchase.
Balanced ETFs are a high-convenience, low-cost portfolio-building tool. But it’s possible that not every component of your balanced ETF will be optimized from a tax point of view for the account you’re using. For example, a balanced ETF held in a TFSA will likely include U.S. and international stocks and thus may expose you to withholding taxes.
You might be able to build a more tax-efficient portfolio choosing your own individual funds. But balanced funds are still a great choice for investors who want a smart, simple way to invest for the long term.
Investing in U.S.-listed ETFs can, in some cases, help you reduce withholding taxes, but there’s an offsetting cost from converting your Canadian dollars into U.S. currency. Mr. Bender said you’re more likely to save on costs with U.S.-listed ETFs if you invest large amounts and hold for a long period of time.
A technique called Norbert’s Gambit can be used to reduce the cost of converting Canadian dollars, but it’s fairly advanced stuff.
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