Before you go shopping for the Couch Potatoes on your holiday wish list, be aware that December can be a terrible time to buy ETFs.
No, it’s not because of all the last-minute shoppers pushing and shoving at the discount brokerage. The reason is that any capital gains that the funds have incurred over the last 12 months are distributed at the end of the year. Although they’re called “distributions,” capital gains are not handed out in cash like dividends or interest. You don’t receive any new shares, and the market price of the ETF won’t change. All you get is a T3 slip showing the amount of the gain, which you’ll need to report on your tax return.
Their gain, your pain
In general, ETFs are extremely tax-efficient, especially if they track broad, cap-weighted indexes. Funds incur capital gains when they sell securities at a profit, and passively managed funds don’t do a lot of selling. (The ETF structure may allow fund managers to avoid taxable gains even when they do sell stocks.) However, a fund may have no choice but to realize capital gains when its benchmark index is changed, forcing the manager to sell some securities and replace them with others. The funds are then required to pass those capital gains on to their investors, usually at the end of the year. (Of course, this is not an issue if you’re investing in an RRSP or a TFSA.)
If you’re a buy-and-hold investor, capital gains are just part of the deal: take comfort in the fact that your fund made some profits during the year and put money in your pocket. However, if you’re thinking about buying into an ETF for the first time, December may not be the time to do it. If you buy shares of the fund now and it pays out a large capital gains distribution at the end of this month, you’ll wind up paying tax on other people’s gains.
When ETFs declare that they will be distributing a capital gain for the year, they name a date of record and an ex-dividend date. (These terms will be familiar to investors who buy individual stocks. This article offers a more complete explanation.) If you buy an ETF before the ex-dividend date and still hold it on the date of record, you’ll pay tax on all of the capital gains accumulated during the year, even though you may have only owned the fund for a week.
ETF providers generally declare any expected capital gains distributions by mid-December. So if you’re looking to buy an ETF in a taxable account, wait until that announcement is made. If the ETF you’re planning to buy expects to distribute a significant gain, delay your purchase until the new year. Any shares you purchase after that date will not be hit with the tax.
Keep in mind, though, that you will be able to deduct the distribution amount from your adjusted cost base.
@alvanson: This is not always done by the brokerage, so you may have to make this adjustment manually. This is from the FAQ on the iShares site:
“For reinvested distributions for an iShares fund, an investor can increase the adjusted cost base (ACB) of the iShares fund by the amount of the reinvested distribution. This adjustment means that any gain realized on a subsequent sale of units will, in effect, be reduced by the amount of the distribution. In this way, you do not pay tax twice on the distribution. In many cases, your brokerage firm will automatically change the ACB to reflect reinvested distributions on iShares funds. However, not all brokerage firms provide this service.”
A note on the re-constitution of CDZ: I called Claymore about a week ago to find out what to expect as CDZ re-constitutes itself in the wake of income trust conversion. Interestingly, all of the effects of this re-constitution will be felt at the end of 2011 as they assess which conversions increased their dividends in 2011 or not.
@Flagen: Claymore just explained to me that the index will be reconstituted in late December.
As much as people seem to love the Aristocrats index, this to me is its biggest weakness. If a company raises its dividend ten years in a row, then keeps it constant one year, it gets removed from the index and stays out for the next five years. That’s why most of the banks got kicked out, even though they are clearly still good dividend stocks.
If you’re currently in the market to buy ETF’s, should you wait until Jan 1?
@Ryan: If the ETFs you want to buy will not be distributing a capital gain (check by clicking the links above) then you don’t have to worry. If they will be distributing a gain, you will likely want to wait until after December 24. Note, too, that if you’re investing inside and RRSP or TFSA you can ignore all of this.
And another thing for others to be aware of: If and when the emerging markets index changes dramatically by the movement of whole countries from emerging to developed, it will produce sizable capital gains issues.
I don’t have any way to assess this: I called Vanguard re. VWO and they basically didn’t give me an answer. Vanguard, as you’ve noted, are very good at managing capital gains because of the structure of their etfs, but I’m not sure even they could cope with the huge turnover created when this comes to pass. My concern was enough to make me move VWO into RRSPs and out of an open account (where it would, as it exists, make the most sense from a tax perspective).
2010 is the first year I started doing the couch potato. I hope to see some tax articles when tax season begins.
@Flagen: It’s true that if a country is promoted to “developed” status it will force emerging markets index funds to sell the stocks from that country. That’s likely to happen with Korea and Taiwan soon, and probably Brazil, too. But keep the “danger” in perspective. It would affect perhaps 10% to 12% of the fund, the capital gains distribution would be a one-off expense, and only half of capital gains are taxable.
That said, if you have room in your RRSP, it would almost certainly be better to keep VWO there. I don’t agree that it makes more sense from a tax perspective to keep VWO in a taxable account, because it’s subject to the 15% withholding tax on dividends, and because there is no tax credit on foreign dividends.
Can you expand on what this means in a TFSA or RRSP? I figure it’s just a wash when you look at payout vs. unit value. Should TFSA investors buy before the capital gains payout?
Can you please also discuss the HST and what it means for investors across Canada in a future posting? Here is a good basic article on Moneyville, but it’s in need of an update for 2011 Couch Potatoes: http://www.moneyville.ca/article/834055–luukko-fund-investors-and-the-hst
@Jon: Capital gains distribution mean nothing for RRSP and TFSA investors. Investors with these accounts pay no tax, period. (Until RRSP funds are withdrawn, of course.)
The HST has already increased the cost of ETFs and mutual funds. These costs will encompass all Canadians, regardless of where they live. As far as I know, no ETF or index fund provider has created special classes of funds for investors outside of Ontario.
Wouldn’t the price of the ETF fall in compensation of the knowledge that the ETF will incur the tax? Kind of like how the price of a stock drops immediately after a dividend has been paid?
Is this called arbitrage?
@Slacker: No, the price will not drop the way it does when a dividend is paid. The capital gains in the fund have already been realized and reinvested during the year, so the price changes occurred then. The “distribution” at the end is really just the waiter handing you the bill at the end of the meal.
Hi – thanks for this article. I have been googling the heck out of this subject and remain uncertain. I thought I understood after reading the article but then one of your comment responses seemed to contradict the article. I’m hoping you can elaborate.
In my case, I first noticed an issue in my 2009 taxes last year and have to deal with it again this year. I had bought a few ETFs mid-year (XCB and XRE) and when my tax bill came, I noticed that the capital gains (line 21 of T3) were higher than the actual total distributions that I had received. In other words, I was being taxed on money I had not received because of my mid-year purchase.
I was uncertain whether I should raise the ACB and chose not to. Your article implies that was correct. But your first comment makes me wonder if I am understanding this all correctly and if I can in fact raise the acb. (my brokerage does not do acb calculations – I do all the math myself).
@Bif: My understanding is that you can indeed raise the ACB to account for the capital gains. But I did not get into the details in the post because this is not my area of expertise. I would suggest you speak to an accountant or tax specialist for a definitive answer.
Hi, thank you for your post. One question, I currently have your global couch potato portafolio using RBC index funds in my TFSA and I am planning to transfer some of them into non-registered account in December ( I need the room for my emergency fund). Will I still receive other people’s taxes even though I held my index funds inside my TFSA most of the year?
Thank you for your help!!
@Carl: The short answer is yes, you could potentially receive a capital gains distribution at the end of the year if the funds are held in a non-registered account in December. It doesn’t matter where they were held previously. But to be certain, I suggest you contact RBC with your question.
Great, informative article, and great reader questions & posts.
I wonder if anyone has put together a list or chart of which discount brokerages actually do provide ACB calculations for ETF’s. (I was thinking of going with Questrade or TD Waterhouse).
I’m just learning and trying to get myself ready to convert my entire portfolio (non-reg., RSP, TSFA, and LIRA) to an all ETF portfolio and to get away from my Advisor/brokerage and the riduculous fees he charges for very mediocre gains. (Yet, he is always rewarded with my fees, whether his perforance results are good or bad.)
Any advice how to educate myself about the ACB tracking I’ll need to do? Any nice Excel templates available? Or, any recommended online claculation and tracking sites?
Thank you!
@Helen: Brokerages are not responsible for tracking ACBs. Although all of them do it in some way, their calculations are not reliable, especially when it comes to non-cash distributions. My colleague Justin Bender and I have co-written a paper explaining how to do it yourself:
https://canadiancouchpotato.com/2013/04/04/calculating-your-adjusted-cost-base-with-etfs/
You’re wonderful! Thank you! I shall read the paper!
@Dan: I don’t quite understand why you place emphasis on not purchasing in December, can you please clarify? If the last Capital gain was realized in June, wouldn’t it be just as bad to make a purchase from July through November as it would be in December?
Thanks, Que
@Que: In theory, yes, but in your example the investor is also getting the benefit of being invested in the fund for six months, during which one expects to benefit from other gains. That’s different from the person who buys in mid-December and pays a year’s worth of taxes on fund held for a couple of weeks.
So it is December once again…
I have cash in a non-taxable account that I’d like to place into the market ASAP, however as this article goes over, I don’t want to be hit with capital gains tax. I’d like to buy, VTI, VXUS, ZCN.
1) How can I calculate the tax exposure? On the Vanguard website, for VTI it states that as of Oct 31, 2013 the realized capital gain is negative $1.15. So wouldn’t this be good to buy now? I guess there is still risk of November having a large capital gain. Also, the dividend is issued quarterly, so am I correct by saying that, at maximum, I have three months capital gains exposure?
I can’t find the same information of realized capital gains for ZCN however.
2) If the above is incorrect, and I should still avoid a December ETF purchase, are there products that give me exposure to a similar index (S&P 500 would be fine), that I can avoid the tax burden?
Thanks
@ETFInvestor: I think you’ve misunderstood this idea, and you’re looking at the wrong numbers. To begin with, you’ve said you;re investing in a non-taxable account: if that’s the case (RRSP or TFSA), this is a non-issue, as you never have to pay capital gains taxes in these accounts. It’s only a potential problem for non-registered accounts. The dividend schedule is also irrelevant here.
The important number to know is the expected capital gain distribution that each ETF is planning for 2013. In the vast majority of cases this will be zero: it typically only happens when an ETF uses currency hedging, or if there has been a change to the index during the year. That actually was the case with some Vanguard Canada ETFs this year, so it is worth checking out. However, as far as I can tell, only iShares has released its estimates for 2013 capital gains distributions. Skimming the list, there seems to be very few with any meaningful distribution, which is a good thing:
http://ca.ishares.com/content/stream.jsp?url=/content/en_ca/repository/resource/2013_estiamted_tax_character_en.pdf&mimeType=application/pdf
I’ll look into this further and see when BMO and Vanguard Canada are planning their announcements and then I’ll do a blog post abut this.
Just a quick clarification, if I buy more shares of an ETF that I already own in December, would this increase the taxes that I will have to pay? or this article only applies when you buy an ETF for the first time in December? thank you for your help!
@Carl: The issue is the same even if you already own shares. Say, for example, you already own 900 units and you buy another 100 in December. If the fund distributes a capital gain, yours will be for all 1,000 shares.