If your long-term savings are all in RRSPs and TFSAs, consider yourself lucky. Using tax-sheltered accounts is easy compared with the plight of investors who are saving in non-registered accounts. From deciding on the right asset location, to harvesting losses, to calculating the adjusted cost base of your holdings, taxable investments are always a challenge. But André Fok Kam’s new book, Tax-efficient Investing for Canadians, will make the job easier.
There are countless books on taxes, but this is the first one I’ve seen that focuses specifically on investments, and it’s loaded with excellent advice. Here are three tips to give you a taste:
Be careful when reinvesting distributions. In the chapter covering the tax implications of mutual funds and ETFs, Fok Kam explains why distributions add no value: “Instead, they merely transfer value from the fund to its unitholders. Investors are enriched when the fund earns a return, not when it transfers value.”
Cash distributions can help pay living expenses if you’re drawing down your portfolio. But investors in the accumulation phase often reinvest all distributions, which is a potential problem at tax time, Fok Kam says. You might not even be aware of what you will owe in taxes, and you may not have enough cash available when you file your return. “You can avoid these surprises by examining your fund statements very carefully when you receive them.” I’d add you might simply avoid DRIPs in taxable accounts, and you should think carefully before choosing funds with high distributions if you don’t need current income.
Understand the superficial loss rule. The book also includes an excellent chapter on capital gains. “A fundamental principle of tax-efficient investing is to defer the payment of tax on capital gains whenever possible,” Fok Kam writes. “It is always better to pay tax later rather than sooner. In the interval, the money can be reinvested and generate additional returns.”
In his discussion of tax-loss harvesting, Fok Kam explains how you can run afoul of the superficial loss rule by purchasing a security before selling shares to crystallize a loss. Most people understand that if you sell a security to harvest a capital loss you must wait 30 days to repurchase it or the loss will be denied. But Fok Kam reminds us of another pitfall. He uses an example of an investor who owns 500 shares of a company that has recently fallen in value. The investor still likes the company’s prospects, so he increases his position to 1,000 shares and then sells 500 to capture a loss. Nice try, but “the [superficial loss] rule applies whenever the same property is bought within 30 calendar days before or after the sale of the original property.”
You can turn dividends into capital gains. You might think you have no control over whether to accept your equity returns in the form of capital gains or dividends. But the book explains one situation where you actually get to choose.
Say you hold 500 shares of a Canadian dividend-paying ETF and the fund announces a payout of $0.50 per share with a record date of Thursday, July 5. The ex-dividend date is two business days before that, or Tuesday, July 3: if you sell the ETF prior to this date you will not receive the upcoming dividend. You should also expect the ETF’s price to drop by the amount of the distribution on the ex-dividend date.
Let’s assume your 500 shares have increased in value by $2,000 as of Monday, July 2. If you sell them on that day (before the ex-dividend date), you would realize a capital gain of $2,000 and you would not receive the announced dividend. However, if you sold the shares the following day (July 3), the share price will have fallen by $0.50, so your realized capital gain would be only $1,750, but you would also receive the $250 dividend. The total proceeds are the same in both cases. But if you’re in a low tax bracket (where Canadian dividends are taxed more favourably than capital gains), you should choose the latter strategy. If you’re in a high tax bracket, you should do the former and take the whole thing as a capital gain.
Tax-efficient Investing for Canadians is published by the IFSE Institute and can be purchased directly from their website (click “Shop as a Guest”). The full cost, including UPS shipping and a processing fee is about $29.
“The ex-dividend date is two business days before that, or Tuesday, July 3: if you sell the ETF on this date or later, you will not receive the upcoming dividend.”
I think that should read “if you sell the ETF before this date, you will not receive the dividend.” If you sell on the ex-date or later, you will still receive the dividend.
But if I understand correctly, you’d also incur a round-trip commission and the bid/ask spread cost if you elected to avoid the dividend (and wanted to get back into the stock or fund after the dividend payment). So taking the capital gain instead of the dividend is much less attractive than it might first appear to be.
@Tyler – in each case you’d incur those costs because in each case shares are being sold.
Unless I’m mistaken in my understanding of the technique described, if you take the dividend, then you’re not selling the shares. If you want the capital gain, then you sell the day before the ex-date, and then you buy again after. There’s an extra sell-buy cycle there.
I think you’re not considering the need to sell in both cases to equalize cash flows. In the example the shares can be sold for $2,000 before the ex-div date. The dividend received would be $250. Therefore, to get to $2,000 of cash inflows, the shares have to be sold.
Sorry, the gain is $2,000, not the value of the shares, but to extract the $2,000 requires a sale in both cases
Maybe we’re thinking about this situation in different ways. If the goal is to liquidate your entire position and the question is “do I sell it all before or after the ex-date?”, then yes, you would have to sell in both cases.
But assuming you really wanted to stay invested, and the sell-and-rebuy is just a manoeuver to avoid tax on the dividend/distribution, then I don’t see why you would sell after the dividend to receive the same amount of cash now.
We both have a capital gain, you’ve chosen to realize yours, while I’ve chosen to defer mine. The gain really has nothing to do with it, except you may have incremental capital gains for every time you sold to avoid the dividend/distribution, and I have one large capital gain if I eventually sell it all at once.
But because you (for example) have decided to sell and re-buy every time a dividend/distribution is paid, you’ve had to pay the cost of the bid/ask spread (and commissions), likely several times per year. If we ignore taxes and trading costs, then we’d be in exactly the same position. But in reality, you’ve spent quite a bit on commissions and a probably a lot more with the cost of the bid/ask. Depending on the specifics of the situation, it might still be worth it to go through this hassle, but the benefit is going to be reduced considerably.
I see what you’re saying, but again, the intention is show how an investor can make preferences on how to be taxed once the decision to sell has been made. I also think, even in your scenario, it depends on individual circumstances as the tax savings can be significant compared to commissions and bid/ask spread considering the availability of super low commission brokers and commission free etf options. But again, I don’t think your scenario is what the article is discussing.
Oh. I thought that’s exactly what the article was talking about. I guess I feel it’s a little strange to happily take dividends as they come, probably for many years, and then get worry about the very last dividend. Every little bit counts, I guess, but I interpreted it as something to consider doing on an ongoing basis.
I agree with you about the commissions, though. Particularly for large accounts, commissions are going to be small compared to the cost of the spread.
I intended to order the book, but the shopping interface and the process is incredibly clunky, probably the clunkiest I’ve seen in years. Sorry, for 2014 this is unacceptable, especially given the price. They could have emailed a PDF for that $16.99 price and be done in seconds.
I think one should worry more about trading fees and MER’s than the tax one pays on capital gains and dividends.
@Tyler: Sorry for joining the discussion late. Yes, the tip in question assumes that you were planning to sell the security for good, not to engage in a dividend-recapture strategy. This isn’t something that would come up often, but on a large position it could help an investor save hundreds of dollars in taxes.
I think Tyler is right.
The line: ” if you sell the ETF on this date or later, you will not receive the upcoming dividend.” should read something like: ” if you sell the ETF on this date or EARLIER, you will not receive the upcoming dividend.”
@Kevin Flossner I’m sorry to hear that you had problems purchasing our product. We’ve spoken to our vendor to see if we can make it easier for guests. Please contact me at cashmore@ifse.ca and I can help you with the purchase.
@Jim and Tyler: My apologies, that sentence was incorrectly worded. I have fixed it now. (The full explanation in the following paragraph was accurate.)
I agree with Kevin that the shopping interface is woefully inadequate. I am not willing to enter my credit card info on such an amateur and outdated looking website. I’m not expecting an amazon.com level of quality, just something at least somewhat professional and modern.
Do you know if IFSE has any plans to put copies of this into library circulation?
One of my biggest pet peeves with various financial blogs and online institutions is that their books never show up in the libraries.
@Kevin Flossner and @Brian S, we’ve provided our vendor with your feedback regarding the user interface. They’ve made some adjustments to make the purchasing process easier and will consider your comments when they update their storefront. Please contact me at cashmore@ifse.ca and I can help you with your purchase.
Wondering if anyone has experience with the tax treatment of dividends from shares of Canadian companies listed on the NYSE and held in $US in a Canadian discount brokerage acct.- ie. Royal Bank. Are these dividends treated as Canadian dividends and do they qualify for the tax credit – or are they treated as US dividends? thx
@davem: Great question. Dividends from Canadian companies traded on a U.S. exchange are eligible for the dividend tax credit. You should also avoid the withholding taxes levied on dividends paid to foreign investors. Make sure you check your T-slips carefully to make sure.
As to the last question regarding holding shares of a Canadian company listing on the NYSE and held on the US side of an account. I can think of no reason one would do this. Every time you receive the dividend you are losing part of that dividend as the dividend is paid to your discount broker in C$ and then converted (at a spread) into US$. There are some US pay preferreds that you might hold that way. If you want US$ dividends buy US dividend payers and hold your Canadian stocks on the C$ side of your account.
Thanks BobT, more on the scenario, I’ve exhausted all tax sheltered accts, I have a large sum of $US that I’d like to keep in $US as I’m using currency as added diversification. If Cdn equities are the most tax efficient equities to hold in non-tax sheltered accts due to lower yields and favorable tax treatment, am I not further ahead from a tax POV to compromise on the dividend currency spread because of the tax treatment of Cdn equities. Also, wasn’t aware that US listed shares held in US acct received dividends in $C?
When you hold a Canadian company in a US$ account you need to determine what currency the company uses to pay its dividend. For example Royal Bank pays its dividend in Canadian dollars so when your broker receives the dividend they would need to convert the dollars to US$. There are Canadian companies that pay their dividends in US$. One of them is Thomson Corps (TRI). There are others. You still get the preferential tax treatment. My problem is with the concept of holding US$ for currency diversification and then using those dollars to purchase Canadian companies. Since those companies are earning their profits in Canada in Canadian dollars if the CAN$ falls in value relative to the US$ then all other things being equal you would see the value of those companies fall in U$ terms. Perhaps you should look at some US companies that have a long history of increasing their dividends. You will give up the dividend tax credit but have actual currency diversification. You might consider VIG for example which is the vanguard etf which invests n those companies
Hi CCP,
I have an online brokerage account with Questrade, where I have an RRSP account, and which I have structured using the “Complete Couch Potato” model portfolio (using the suggested ETF funds). It is doing fine. And by the way, I have nothing but good things to say about my experience with Questrade so far; they have been extremely helpful, and have responded in minutes to my requests. The online tools of theirs that I have used are very good (includes monthly online performance reports).
My question: I am considering opening an account (with Questrade perhaps, if it’s suitable) for NON-registered investing (I am close to maxing out on my RRSP contributions); is there a simple strategy for this? In particular, I would like to minimize the tax calculations. For example, is it better (from a tax-simplification perspective) to invest in (index) mutual funds rather than ETFs for non-registered investments?
@Jean: Thanks for the comment. In a non-registered account index mutual funds tend to be easier when it comes to ACB calculations, because this is typically done at the fund level rather than by the brokerage. That’s certainly one option. But since you won’t have access to the TD e-Series funds (which are much cheaper than the other options) it’s probably worth learning to track your ACB with ETFs. If you use a service like AdjustedCostBase.ca and follow our white paper it’s not that difficult.
https://canadiancouchpotato.com/2013/04/04/calculating-your-adjusted-cost-base-with-etfs/
@CCP: Thank you for the prompt response. I read your white paper, and yes, I am sure I can manage the ACB calculations with that guidance. Thanks for your help.
I have read you say that for tax efficiency within an RSP the best Canadian listed Developed/International market ETFs to chose (after first deciding on the index you want to follow) is to look for one:
1. Not hedged
2. Holding the stocks directly
Based on that the only ETF from iShares meeting those points would be XEU, as the rest of the listings (XEF, XUS, ect) clearly show the ETFs are wrappers that only hold the US version.
For BMO the list appears to be longer with ZEA, ZDY, ZLU and ZSP all listing individual stock holdings.
For Vanguard the list is also long with VDU, VFV VUN, VE and VA.
So two questions:
1. Are BMO and Vanguard just not showing the wrappers or do all those ETFs actually hold the stocks directly? (and so are all decent tax choices for an RSP)
2. In a non-Registered account does the direct holding of stocks or just being a wrapper make any difference?
Thanks!
@Peter: All of the Vanguard international ETFs are wrap products. They all hold US-listed versions of Vanguard ETFs. This information is explained on the site. For example, in “Investment Approach” on VDU’s main page it says: “Invests primarily in the U.S.-domiciled Vanguard FTSE Developed Markets ETF.”
BMO, unlike iShares and Vanguard, does not have an affiliated US arm, so they are less likely to use the wrap structure. In some cases (like their emerging markets fund, ZEM) they hold a portion in iShares ETFs. You can check this by clicking the “Holdings” tab on their website.
In a non-registered account the wrap structure still matters for international equities, though the effect is not as big as in RRSPs:
https://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/
Thanks, I thought that might be the case with Vanguard. Click on holdings and you get a list of holdings, not the list of US ETFs that carry those holdings, while iShares and BMO clearly indicate the ETFs they hold.
Though I now see that text you quoted.
It would be great if they had an ebook version of this. Would surely save them $$ as well!
@CCP
Can ETF funds be transferred from a TFSA to an RRSP without selling them then buying back in an RRSP?
I am just starting out and my income makes TFSA the better option for now but I will eventually want to use both accounts.
Basically I want to start out with ETF portfolio in my TFSA then move some over to RRSP in the future when I’m in a higher tax bracket.
Thanks
@Chris: No, you cannot make in-kind transfers from a TFSA to an RRSP, but there would be no meaningful benefit to doing so anyway. It would simply save you a small amount in trading commissions. One option to consider, however, is purchasing your ETFs in an RRSP today (assuming you have contribution room) and simply waiting to claim the tax deduction until you are in a higher tax bracket:
http://business.financialpost.com/2013/02/22/the-difference-between-an-rrsp-contribution-and-deduction/
You will have less flexibility around withdrawing money from an RRSP compared with a TFSA, but that could be a good thing if it removes the temptation to spend it.
I just stumbled across this post and Googled the book. To my pleasant surprise, it’s now being offered as an e-book on Google Play, on sale for $9.99.