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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.

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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.

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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.

How ETFs are taxed in TFSAs

Tables were created with the help of Justin Bender of PWL Capital

ETF typeTax implicationsIs there a way to reduce the tax impact?ETF suggestions from PWL Capital
Canadian equity fundsDividends and capital gains are tax-free.No.VCN-T, XIC-T, ZCN-T
Canadian dividend and income fundsDividends and capital gains are tax-free. The return of capital these funds typically include in their distributions to unitholders also has no tax implication. No.
U.S. equity funds Dividends and capital gains are tax-free, except for a non-recoverable 15% U.S. withholding tax on dividends.No.XUU-T, VUN-T
International equity funds Dividends and capital gains are tax-free, except for non-recoverable withholding taxes (typically 6% to 12%) on dividends. If a Canadian-listed international equity ETF holds a U.S.-listed international equity ETF for its stock exposure, or if an investor holds a U.S.-listed international equity ETF directly, an additional non-recoverable 15% U.S. withholding tax on dividends will also apply.You can avoid the additional 15% U.S. withholding tax by using a Canadian-listed ETF that holds the underlying international stocks directly.XEF-T, VIU-T
Canadian bond fundsAll interest and capital gains are tax-free.No.VAB-T, ZAG-T, XBB-T

Source: PWL Capital

Note: PWL does not use dividend and income ETFs in client portfolios

How ETFs are taxed in RRSP and RRIFs

ETF typesTax implicationsIs there a way to reduce the tax impact?ETF suggestions from PWL Capital
Canadian equity fundsDividends and capital gains are tax-deferred until withdrawal. At that point, they are taxed as regular income.No.VCN-T, XIC-T, ZCN-T
Canadian dividend and income fundsDividends and capital gains are tax-deferred until withdrawal. At that point, they are taxed as regular income. The return of capital these funds typically include in their distributions to unitholders also has no tax implication inside the plan.No.
U.S. equity funds Dividends and capital gains are tax-deferred until withdrawal. At that point, they are taxed as regular income. If a Canadian-listed U.S. equity ETF holds a U.S.-listed U.S. equity ETF for its stock exposure, a non-recoverable 15% U.S. withholding tax on dividends will apply. These withholding taxes will also apply if the Canadian-listed U.S. equity ETF purchases the U.S. stocks directly.Use a U.S.-listed U.S. equity ETF, as withholding taxes do not apply.ITOT-A, VTI-A
International equity funds Dividends and capital gains are tax-deferred until withdrawal. At that point, they are taxed as regular income. Non-recoverable withholding taxes (typically 6% to 12%) on dividends apply. If a Canadian-listed international equity ETF holds a U.S.-listed international equity ETF for its stock exposure, an additional non-recoverable 15% U.S. withholding tax on dividends will also apply.To avoid the additional 15% U.S. withholding tax, use either a Canadian-listed ETF that holds the underlying international stocks directly, or hold a U.S.-listed international equity ETF directly.XEF-T, VIU-T, IEFA-A, VEA-A
Canadian bond fundsAll interest and capital gains are tax-deferred until withdrawal.No.VAB-T, ZAG-T, XBB-T

Source: PWL Capital

Note: PWL does not use dividend and income ETFs in client portfolios

How ETFs are taxed in taxable accounts

ETF typesTax implicationsIs there a way to reduce the tax impact?ETF suggestions from PWL Capital
Canadian equity fundsCanadian dividends are eligible for the dividend tax credit. Capital gains can be deferred and are taxed at half your marginal rate when realized. Capital gains can be deferred and are taxed at half your marginal rate when realized.No.VCN-T, XIC-T, ZCN-T
Canadian dividend and income fundsCanadian dividends are eligible for the dividend tax credit. Return of capital will reduce the adjusted cost base on an investment, which could increase your future capital gains. Capital gains can be deferred and are taxed at half your marginal rate when realized.No.
U.S. equity funds Dividends are fully taxable. A 15% U.S. withholding tax applies, but may be recoverable with the foreign tax credit. Capital gains can be deferred and are taxed at half your marginal rate when realized.No.XUU-T, VUN-T
International equity funds Dividends are fully taxable. If the fund holds the international stocks directly, withholding tax (typically 6% to 12%) on dividends applies, but may be recoverable with the foreign tax credit. If a Canadian-listed international equity ETF holds a U.S.-listed international equity ETF for its stock exposure, or if an investor holds a U.S.-listed international equity ETF directly, the first layer of withholding tax (typically 6% to 12%) on dividends is lost and not recoverable. A second layer of U.S. withholding tax (at 15%) applies to funds using a U.S.-listed international equity ETF for their stock exposure and to investments directly in a U.S.-listed international equity ETF. This 15 per cent tax may be recoverable through the foreign tax credit. Capital gains can be deferred and are taxed at half your marginal rate when realized.Use a Canadian-listed ETF that holds the underlying international stocks directly.XEF-T, VIU-T
Canadian bond fundsInterest is fully taxable. Bonds trading at a premium to their redemption price (because they were issued when interest rates were higher) are particularly tax-inefficient because of their high coupons. You're taxed at those high coupons, even if your actual yield-to-maturity is lower. The coupon is the interest rate paid by a bond at the time of issue. Capital gains can be deferred and are taxed at half your marginal rate when realized.Use a specialized ETF that holds bonds trading at a discount or par, or use a GIC ladder instead. ZDB-T

Source: PWL Capital

Note: PWL does not use dividend and income ETFs in client portfolios

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