Archive | Taxes

How Budget 2015 Will Affect Investors

Yesterday’s federal budget included several changes that will affect investors—in the future if not immediately. Let’s look at the three most important announcements, with a focus on how they may apply to those who use an index strategy with ETFs:

The biggest headline was the increase in annual TFSA contribution room from $5,500 to $10,000, beginning immediately.

Minimum withdrawals from RRIFs were reduced significantly.

Investors who hold foreign property (including US-listed ETFs in non-registered accounts) will be able to report this to the Canada Revenue Agency in a more efficient way.

Asset location just got more interesting

If you’re juggling TFSAs, RRSPs and non-registered accounts, asset location is a challenge. To manage your portfolio in the most tax-efficient way, you should consider which asset classes (equities, bonds, REITs and so on) are best held in which type of account. This isn’t straightforward. You can make a strong argument for holding bond ETFs in a registered account because they are so tax-inefficient. But if a TFSA can shelter you from taxes over an entire lifetime, shouldn’t it be reserved for assets with the highest growth potential—in other words, stocks?

There is no single right answer: an awful lot depends on individual circumstances such as your current tax rate,

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When Discount Bonds Are Hard to Find

Everyone loves a discount, but if you’re buying bonds these days you may be out of luck.

Just over a year ago, the BMO Discount Bond (ZDB) was launched as a tax-efficient alternative to traditional bond ETFs. ZDB tracks the broad Canadian market, but it selects bonds trading at a discount, or at a very small premium. Discount bonds have a lower coupon than comparable new bonds, and they will mature with a small capital gain. That combination is more tax-efficient than premium bonds, which have higher coupons and mature at a loss.

A discount bond ETF is a great idea for non-registered accounts, but it faced challenges from the beginning. After many years of interest rates trending downward, there simply aren’t many discount bonds in the marketplace. Traditional broad-market bond ETFs hold between 500 and 900 issues, but ZDB holds just 55.

This constraint has become more urgent after the Bank of Canada unexpectedly cut short-term rates in January. Yields on intermediate and longer-term bonds also fell, driving bond prices up sharply. Suddenly bonds that were trading at a discount were priced at or above par.

In my blog post introducing ZDB,

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Which Bond ETF Is Most Tax-Efficient?

Back in September, my colleague Justin Bender and I published a white paper entitled After-Tax Returns: How to estimate the impact of taxes on ETF performance. Justin has now updated his Excel calculator and made it available for free download on his blog.

Recently Justin put his own methodology to work by measuring the 2014 after-tax returns of 10 short-term bond ETFs. As it happens, 2014 was a relatively good year for short-term bonds: as interest rates fell again, ETFs in this asset class delivered returns between 2.3% and 3.5%. But as we have written about before, traditional fixed income ETFs tend to be full of premium bonds, which are notoriously tax-inefficient because of their high coupons. If you held one of these ETFs in a non-registered account, your after-tax return would have been lower.

Launched in 2013, the First Asset 1-5 Year Laddered Government Strip Bond (BXF) was designed to be a tax-friendly alternative. Strip bonds do not make interest payments like traditional bonds do: rather, they are sold at a discount and mature at par value.

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Taxable Consequences of Norbert’s Gambit

Norbert’s gambit with the Horizons US Dollar Currency ETF (DLR/DLR.U) is often the most cost-efficient way to convert Canadian dollars to US dollars, or vice-versa. Our series of white papers focused on performing the gambit in an RRSP, but if you’re swapping currencies in a non-registered account, you should be aware that it can have tax consequences.

At brokerages such as RBC Direct and BMO InvestorLine, you can place the buy and sell trades within minutes of each other. But several other brokerages do not allow you to journal the ETF from the Canadian side of your account to the US side (or the other way around) until the buy trade settles. In both cases, however, there will be at least three business days for the transaction to be complete, and the US-Canadian exchange rate can move significantly during that time. A big swing could stick you with a capital gain or loss when you make the sale.

What’s more, calculating this gain or loss can be tricky, because both the purchase and sale need to be reported in Canadian dollars. That means any transaction in DLR.U needs to be converted from US dollars.

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The Wrong Way to Think About Withholding Taxes

If you live in a big city, you can save a few cents per litre on gas by travelling to the boonies. But you also understand that it doesn’t make sense to burn $10 of fuel driving out of town so you can save $8 on a fill-up. Yet many investors seem to be making a similar error by trying to avoid foreign withholding taxes in their registered portfolios.

About a year ago, Justin Bender and I co-wrote a white paper that estimated the cost of foreign withholding taxes. There are far too many details to review here, but among the most important is that withholding taxes on dividends are lost if you hold a Canadian mutual fund or ETF of foreign stocks inside an RRSP or TFSA. If you hold the same fund in a non-registered account, however, you can recover the withholding taxes by claiming a credit on your tax return.

Sometimes I feel like we created a monster with this paper, because I have received many e-mails from readers who have misunderstood this information and made poor decisions as a result.

Here’s an example: Cyril wants to build a balanced portfolio that includes US and international equities,

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Tracking Error on International Funds

I recently received an email from a reader, J.W., who wanted to know why the tracking error on some popular Vanguard international equity ETFs were so high in 2014. He noted, for example, that the Vanguard FTSE Developed ex North America (VDU) lagged its benchmark index by 1.62% last year, far more than one would expect.

An index fund’s tracking error is the difference between the performance of the fund itself and that of its benchmark. If the index returns 10% on the year and the fund delivers 9.8%, the tracking error is 0.20%, or 20 basis points. But what could possibly cause a fund to show a tracking error of 162 basis points?

Any time you see a surprising number like this, it’s important to determine the reason: otherwise you risk making a bad decision because you’re working with inaccurate or misleading information. If an index were to lag its benchmark by more than 1.6% because it was badly managed, then you should look for a better alternative. But Vanguard has a long record of tight tracking error, so something else has to be going on here—and indeed it is.

Back on track

To understand VDU’s large tracking error—and why it’s not as bad as it looks—let’s look at the reasons its performance deviated so far from the index.

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The Couch Potato Goes Abroad

Andrew Hallam’s Millionaire Teacher remains one of the best introductions to index investing. When I reviewed it three years ago, I stressed that Andrew writes with authority because he follows his own advice.

In his new book, The Global Expatriate’s Guide to Investing, Andrew shares more of his first-hand knowledge about managing an indexed portfolio outside your home country. Andrew left Canada in 2003 and spent years as a teacher in Singapore before settling (at least for now) in Mexico earlier this year. So he knows all about the challenges—and the surprising benefits—of being an expat investor.

Most of his book’s advice applies equally to homebodies: the first several chapters lay out the case for using a passive strategy, whether with plain-vanilla ETFs, a fundamental index strategy, or the Permanent Portfolio. Then he explains how expats can put these ideas into practice. I asked Andrew to elaborate on some of the key points for Canadians living abroad.

What are the most important tax issues that Canadian expat investors need to be aware of?

AH: So much depends on where the expat is living.

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Ask the Spud: Bond ETFs in Taxable Accounts

Q: Can you share your thoughts about the BMO Discount Bond (ZDB) and the Horizons Canadian Select Universe Bond (HBB) as long-term holdings in a taxable account? – D. F.

Earlier this year BMO and Horizons both launched bond ETFs specifically designed for taxable accounts. These two funds have very different structures, and each has its strengths and weaknesses. So let’s dig more deeply into each fund to help you decide which might be right for your portfolio.

Before we discuss these specific funds, let’s review the problem with holding traditional bond ETFs in non-registered accounts. Most bonds these days trade at a premium (higher than their par value), because they were issued when interest rates were higher. Premium bonds are perfectly fine in your RRSP or TFSA, but they are notoriously tax-inefficient and should not be held in non-registered accounts.

 Do you want a discount or a swap?

The BMO Discount Bond (ZDB), launched in February, is similar to traditional broad-market bond ETFs, such as the iShares Canadian Universe Bond (XBB), the Vanguard Canadian Aggregate Bond (VAB) and the BMO Aggregate Bond (ZAG).

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Tax Loss Harvesting Revisited

No one likes to see their investments plummet in value, but it’s going to happen many times over your lifetime. If you’ve got a strategy for tax loss selling, you can make the best of the situation by harvesting capital losses that can be used to offset capital gains. That gives you an opportunity to reduce or defer taxes in the future, or even recover taxes you paid in past.

In a blog post on September 26, I noted that Canadian equities had fallen by about 5% since the beginning of the month, which could have triggered one such opportunity. (A useful rule of thumb, courtesy of Larry Swedroe, says a security should be sold when the loss is at least 5% and at least $5,000.) If you had recently made a large purchase of the Vanguard FTSE Canada All Cap (VCN), for example, you might have sold it that week to realize a capital loss and then repurchased the iShares Core S&P/TSX Capped Composite (XIC) or a comparable fund. As long as the replacement ETF tracks a different index you’ll maintain your exposure to Canadian stocks while also steering clear of the superficial loss rule.

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