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A Super Tax Efficient Index ETF Portfolio for your Non-Registered Account

For regular followers of MDJ, you will know that I’m a fan of both index and dividend investing.  I use index investing for long-term, hands off portfolios, such as my spouses RRSP and LIRA (from her commuted defined benefit pension), and my children’s education fund.

Related:  6 Ways to Index Your Portfolio

I use the dividend growth investing strategy to produce growing passive income to one day achieve financial independence – ideally sooner rather than later.  However, one issue with long-term dividend investing in non-registered (ie. taxable) accounts is the tax leakage.  In other words, all those juicy dividends being generated are also subject to tax.

The Portfolio Leak

While the tax on a Canadian publicly traded company dividend is fairly tax efficient (due to the dividend tax credit), it still creates a drag on the portfolio.  Since a stock market index is a collection of the largest companies in any particular country (or sector) – large blue chip companies generally pay a dividend, thus index ETFs generally have a dividend yield associated with them.  To add to this, international dividends and bond interest are taxed like income, which can be high for some and definitely taxed higher than Canadian dividends.

The dividend yield on an index ETF/fund may be smaller than a dedicated dividend portfolio, but it’s still a tax drag that can add up over the long term while in a taxable account.  Especially so for high-income employees who are already in a high tax bracket.

To solve this tax issue, the most efficient choice is to keep all of your money in tax-sheltered accounts (ie. RRSP/TFSA etc).  However, what if you’ve maxed out all of those accounts and have savings left over that can be invested in the market?  That’s where tax-efficient ETFs come into play.

The Solution for Taxable Accounts

Horizons has created index ETFs that pay 0% in distributions or dividends. Instead, you will only be taxed with capital gains tax when you sell down the road. The dividends are still there but used to compound instead of being paid out.

This is attractive in that the ETFs can grow tax-free while you are accumulating and earning a salary.  Then, when it comes time for retirement and theoretically lower income, you can sell off small portions of your portfolio and only pay capital gains tax.

Next question is, how exactly are they able to do this?  This involves a complicated financial instrument called swaps.  Essentially, Horizons uses National Bank as a counter-party to deliver the returns of the index.  So if the TSX 60 (Canadian large cap index) returns 5%, then National Bank is responsible for paying Horizons 5%.  Sounds risky?  It’s actually not as risky as the word “swap” sounds.  Canadian Couch Potato explains that if National Bank defaults on their payment to Horizons, then it’s only the gain that is at risk, not the original invested amount.  Also, if National Bank defaults, we likely have bigger problems in the Canadian stock market, thus no returns would be owed to Horizons.

The Leak-Free Portfolio

A basic globally diversified indexed portfolio typically involves the following parts:

  • Canadian Index
  • US Index
  • International Index
  • Bond Index

Up until recently, Horizons ETFs was missing tax efficient international coverage but that changed with the introduction of the Horizons Intl Developed Markets Equity Index ETF with the ticker HXDM.  This ETF gives exposure to the MSCI EAFE index which covers developed markets outside North America.

With the missing piece of the puzzle, here is a globally diversified no-leak indexed portfolio from Horizons:

  • Canadian Index (TSX 60): HXT (MER: 0.07% reduced to 0.03% until Sept 2018)
  • US Index (S&P 500): HXS (MER: 0.40%)
  • International Index (MSCI EAFE):  HXDM (MER: 0.50%)
  • Canadian Bond Index: HBB (MER: 0.24%)

If you had 25% of each ETF, the total portfolio would cost about 0.30% which is not bad for a tax-efficient portfolio.  Having the option of using these ETFs adds another weapon in overall tax planning.

For ultimate efficiency, consider opening a non-registered account with a brokerage that allows you to trade ETFs commission-free.  I recently opened a non-registered account with Questrade (her TFSA and RRSP already maxed out) for this purpose.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 23 comments… add one }
  • Leo Ly @ isaved5K.com October 2, 2017, 9:42 am

    For HXS and HXDM, are these two ETFs hedged to Canadian dollars? If there is no hedging, then your potential income can be greatly affected years down the road if the Canadian currency appreciates against the world currencies. If there is hedging, what is the annual cost as part of the portfolio to do the currency hedging?

    I am currently using the ishare XSP ETF to invest in the S&P 500 index. This ETF is hedged to the Canadian dollars. I am looking for an unhedged ETF to get some exposure to the USD.

    • FT FT October 2, 2017, 9:49 am

      Leo, my understanding is that both are unhedged. I typically stick with unhedged ETFs for efficiency sake.

  • EngPhys October 2, 2017, 11:54 am

    1. FT – thanks for putting this up, I didn’t know about the new ETF. I use the total return swaps in my non-registered acccounts, so this will really help.
    2.. The best un-hedged S&P 500 ETF is VFV. XUS is also good. You might want to go with XUU which is even cheaper and has many more stocks in it. However, for non-registered accounts HXS is the best if you are willing to accept the added risks of a swap based ETF.

  • Yun October 2, 2017, 2:05 pm

    Thank you for another very informative post. This topic came timely as I am just going to put $25k in a non-registered Smith Maneuver account. I was thinking of using MAW 105 for simplicity. But this post makes me think whether I should do an indexing portfolio. Other than a higher MER, what’s your thought about MAW 105 vs an equally weighted ETF portfolio? Thank you in advance. Cheers, Yun

    • Oslerscodes October 2, 2017, 3:42 pm

      Careful with swap-based ETFs for a leveraged (ie. Smith Maneuver) strategy. The interest deduction of the investment loan is based upon the investment having the capacity to pay income. Horizon swap-based ETFs dont pay income (nor could they) and the CRA would challenge your investment loan interest deduction.

      • FT FT October 2, 2017, 6:27 pm

        +1 cra expects that your investments generate some form of income . These ETFs were created to avoid income .

    • May October 2, 2017, 6:24 pm

      Shouldn’t a Smith Maneuver account generate enough income to cover the interest cost?

    • Yun October 2, 2017, 7:40 pm

      Oslerscodes and FT, Thank you both for pointing out the zero-income tax consequence. That makes sense.

  • Bernie October 2, 2017, 6:31 pm

    You might want to recheck the MER’s for HXS, HBB and the new HXDM with Horizons as they seem rather high. Morningstar shows the MER’s to be 0.14% for HXS and 0.17% for HBB. The MER for HXDM was unavailable.

    • FT FT October 2, 2017, 6:34 pm

      Hi Bernie, the MERs that i quoted include the “swap” fee charged by the counter party. The Canadian index is so low because the counter party does not charge a swap fee for that ETF.

  • DC October 3, 2017, 2:29 pm

    Thanks for the post. I can see the benefit of no dividends during the accumulation face. But I thought one advantage of dividends (from Canadian companies) at retirements was that (depending on income level) those dividends could be close to tax free. If you one is aiming for early retirement the accumulation face should be a shorter period than the retirement one. In this light wouldn’t it be better to have dividend paying ETF (from Canadian companies)? than having to pay capital gain taxes during retirement? And having to deplete the ETF principal (selling stocks), at the same time… Thanks,

  • GYM October 3, 2017, 5:29 pm

    Thanks for sharing this alternative! I hadn’t heard of the term swaps before. Since I’ve filled up my RRSP and TFSA space I’ve been investing in my non-registered portfolio. I’ll definitely look into this for tax optimization.

  • mike October 5, 2017, 4:43 pm

    How do these work when it comes to foreign withholding tax?

    Thanks

    • FT FT October 5, 2017, 4:51 pm

      Hi Mike, since there are no foreign dividends, I don’t see how foriegn withholding tax would apply. I’m going to look into this further .

      • Potato October 8, 2017, 7:20 pm

        My understanding (which is shaky on these complex products) is that the FWT is a big part of why the swap fee is higher for the foreign versions (there are dividends at some point in the chain unless the whole thing is synthetic).

  • Ted October 9, 2017, 1:05 pm

    Do the tax savings actually overcome the higher MER drag?

    • FT FT October 9, 2017, 7:04 pm

      Ted, there are a couple of factors for that comparison, specifically, your current income and tax bracket. Say you compare to XEF which has a dividend of 2.83% at a hypothetical tax bracket of 40%. If you own $1,000 worth paying 2.83% international dividend in a taxable account, you would pay $28.30 * 40% = $11.32 for every $1k that you own in tax. The posted MER of XEF is 0.22% which is $2.20 for every $1k that you own. If you include tax, you are paying $11.32 (tax) + $2.20 (MER) = $13.52 or 1.35% MER including taxes in a non-registered account.

      Compare this to HXDM which essentially covers the same index as XEF, at a MER of 0.50%. Plus you don’t need to track any ROC or other misc distributions through the years.

  • CK October 13, 2017, 11:39 pm

    We’d have to check the math on this but assuming you have $1000 today and get 2.8% (XEF) dividend at the lower dividend tax rate…. does the future value 20 years from now at a tax bracket at 40% still make XHT worth it? (We’re assuming taxes will be lower in 20 years and we’ll be making less than $40k?… I expect the answer to be “no” to both.)

    I spent time with my financial advisory looking at my LIRA and if we leave Canada for 2 years we should be able to withdraw our LIRA at a 25% penalty (https://www.fsco.gov.on.ca/en/pensions/lockedin/faq/Pages/nonresident.aspx). Assuming the same growth rates, taking the penalty today net $100k more in savings than leaving it and taking the full tax hit down the road. This article feels like a very similar thing don’t you think?

  • Brandon October 20, 2017, 2:14 pm

    I noticed there is HXS.U.TO and HXS.TO is there any difference?

    • Brandon October 20, 2017, 3:49 pm

      never mind you can delete this comment .U is for US dollars.

    • FT FT October 20, 2017, 3:56 pm

      I just looked it up and it appears that HXS.U is in USD.

      http://www.horizonsetfs.com/etf/HXS-U

      Not a bad idea if you have a USD cash in a non-registered account.

  • jamie October 22, 2017, 1:50 pm

    FT, interesting article, thanks. Any specific thoughts on holding these type of ETFs in non-regd corporate accounts?

    • FT FT October 22, 2017, 2:02 pm

      I like them for corp accounts and looking at hxs to help diversity holdings.

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