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The Real MER on ETFs – Foreign Withholding Taxes on ETFs

withholding taxes on ETFs

I’ve written a lot about index investing as one of the best strategies for beginner and experienced investors alike.  It’s a strategy that I follow with a large portion of my portfolio to get ex-Canada (outside Canada) diversification (I use dividend investing for my Canadian exposure).  Not only do I use this strategy in my own portfolio, but also our family portfolios are also indexed. 

For my wife, we have her RRSP and LIRA in either iShares XAW or the components that make up XAW (XUU, XEF, XEC).  For my kids, I have a family RESP setup that uses the TD E-series family of low-cost index mutual funds.

Related: Here are 6 ways to index your portfolio

Why Index ETF Investing

Needless to say, we have a significant portion of our wealth tied to this strategy.  Here are some of the reasons why I recommend Index ETF investing:

  1. Is a great way to get international diversification – Canadian’s tend to have too much of their investments tied to Canada (I’m also guilty of this). I tend to use iShares XAW for my international diversification held in a registered account (RRSP/TFSA). 
  2. Can lower your portfolio’s management expense ratio (MER) when compared to mutual funds – Even if you have lowered your portfolio MER by choosing index mutual funds, you can essentially cut your MER in half by going with ETFs.  Just reducing your MER by a little can have drastic results over the long term.
  3. Will outperform the majority of mutual funds out there today – The MER matters and likely the reason why active mutual funds do not beat the index.  Say the index returns 7% in a year.  A 2.5% MER active mutual would need to return at least 9.5% just to match the index.  My money is on the index.
  4. Can be easy and hands off – Perhaps the biggest benefit of index investing is that it’s super easy.  When I didn’t think that index investing could get any easier, the big ETF players have released all-in-one ETFs that automatically rebalance.  So now you don’t even need to rebalance your portfolio.

What is Foreign Withholding Tax?

When you buy U.S dividend stocks in a taxable account, you may notice that the dividend will have 15% withheld (providing you filled out a W-8BEN, otherwise 30%).  Although you see money coming out of your account, it’s used to offset your taxes owing on that dividend when you file your tax return (taxed like interest).  So the withholding tax is not lost.

What about US dividend stocks within an RRSP?  For RRSPs, there is a tax agreement between Canada and the US that eliminates the 15% withholding tax on US dividends.  While this is great, the agreement does not extend to TFSAs so US dividends within a TFSA will face a non-recoverable 15% tax.

Foreign Withholding Tax on ETFs?

So what about US and international ETFs?  This is where it gets tricky!

While holding US stocks directly in an RRSP gets preferential tax treatment, did you know that an ETF that holds underlying ETFs does not qualify for the tax exemption?  So essentially with the additional embedded tax, you are paying a higher MER than you think!

International equities would be subject to withholding tax in an RRSP/TFSA, and gets even larger if the international ETF holds underlying ETFs.  The bright side is that the more popular international equity ETFs like iShares XEF and Vanguard VIU hold individual stocks, which results in only one level of withholding tax.

An Example

For example, one of my favorite ways to get US exposure in my RRSP is through the iShares XUU because of the diversification and because of the extremely low MER of 0.07%. 

However, since XUU holds underlying ETFs, it would face foreign withholding tax in the tune of 0.32%.  This results in a total MER of 0.39% when held in an RRSP/TFSA.

As another example, one of my favorite international equity ETFs within my RRSP is owning iShares XEF.  This ETF has a MER of 0.22%, but since it holds stocks directly (and not other ETFs), the resulting withholding tax is 0.30%.  When holding in an RRSP/TFSA, the resulting MER is 0.52%.

Calculating Withholding Tax on ETFs

Justin Bender, from Canadian Portfolio Manager blog, does a great job explaining ETF withholding tax and has even created a nifty calculator that really helps simplify the concept.

Without getting into the details of how to calculate the withholding tax, let’s get into the good stuff and show the total MER including withholding tax in each account type of some popular ETFs.

U.S Equity ETFs

ETFTFSARRSPNon-Reg
XUU (CAD)0.39%0.39%0.07%
VUN (CAD)0.46%0.46%0.16%
ITOT (USD)0.35%0.03%0.03%
VTI (USD)0.34%0.04%0.04%

International Equity ETFs

ETFTFSARRSPNon-Reg
XEF (CAD)0.52%0.52%0.22%
VIU (CAD)0.54%0.54%0.23%
IEFA (USD)0.84%0.36%0.36%

Global Equity and All-in-One ETFs

ETFTFSARRSPNon-Reg
XAW (CAD)0.58%0.58%0.26%
VXC (CAD)0.75%0.75%0.38%
VGRO (CAD)0.46%0.46%0.27%
XGRO (CAD)0.41%0.41%0.22%
VBAL (CAD)0.44%0.44%0.27%
XBAL (CAD)0.36%0.36%0.22%

*Note that dividends received from non-Canadian companies in non-reg accounts are taxed like interest (ie. added to your marginal tax rate).  Also note the cost of foreign currency exchange from CAD to USD. 

Final Thoughts

As you can see from the table above, withholding taxes can really add to the overall MER of your portfolio – especially in registered accounts. No longer is the advertised MER of XUU (covers US market) 0.07%, but after withholding taxes in an RRSP, it’s 0.39%! 

However, you can further reduce your MER if you are willing to transfer your CAD to USD, and buying the US versions of the ETF – like VTI instead of XUU.  But note that there is an added cost of doing foreign currency exchange – but can also be minimized using Norbert’s Gambit

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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 }
  • Avatar Richard Tobin May 27, 2019, 10:03 am

    Thanks for the article. In the line XUU (CAD) you indicate the Non-Reg MER as 0.7%. Should that be 0.07%?

    • FT FT May 27, 2019, 10:49 am

      Thanks Richard, fixed!

  • Avatar Stone May 27, 2019, 11:44 am

    I pretty much hold all of the equity component of my portfolio in a non-registered account. The reason for this is that I don’t have enough room. I have $270,000 in RRSPs, $63,000 in TFSAs and $590,000 in a non-reg account. I maintain a 60/40 equity/fixed income portfolio and so about $369,000 is in VAB. The equities are split by XUU, VCN, XEF and XEC. Because of the monthly interest payment at 2.80% for VAB, I shelter what I can in the RRSP and TFSA. The other ETFs have lower % payouts so this way my tax bill is a bit less. After reading your article, I feel a bit better about having the international component in the non-reg account but not sure if how I did this is the optimal setup.

    • Avatar Adrian May 29, 2019, 4:33 pm

      One thing to keep in mind, in addition to income tax, is the actual rate of return of the investment. Sheltering low-interest GICs in a TFSA vs something with a higher rate of return can be penny wise and pound foolish.

  • Avatar Rahim Khataw May 27, 2019, 3:12 pm

    Hey FT,

    How about giving some acknowledgement/credit to the person who discussed this with you a few weeks ago…

    I also had similar e-mail conversations a few weeks ago with Justin B who you acknowledge above and Dan from Canadian Couch Potato about this same topic.

    Thank, RK

    • FT FT May 27, 2019, 9:25 pm

      Thanks RK. You one of a number of readers who have asked me about the topic over the last few weeks.

      • Avatar Rahim May 28, 2019, 10:32 pm

        Thanks for the acknowledgement FT.

        Knowledge is power, now that more people know about this, what is the solution…Like I mentioned via e-mail, last year I paid almost $500 in foreign withholding taxes over the various accounts. A problem cannot exist without a solution. How do you turn this knowledge into a slightly edge in our favour ;)

        Thanks, RK

        • Avatar Elbyron June 28, 2019, 6:37 pm

          The solution is already mentioned in the “Final Thoughts” section of the article, though it deserves more elaboration. If you’re holding ETFs in your RRSP that are not exempt from FWT because they are Canadian ETFs that hold US ETFs, then what you need to do is sell the Canadian version, use Norbert’s Gambit to convert the funds to USD, and buy the US-listed version directly. If you’re holding foreign ETFs in your TFSA , you should think about how your overall portfolio is allocated among your accounts. Try to position the foreign holdings in RRSP or non-registered (using US-listed ETFs), and keep the Canadian and bond holdings in the TFSA.

  • Avatar PK May 28, 2019, 10:12 am

    Elegant explanation of confusing issue.
    One question: Assuming a 15% withholding tax on a US Equity ETF XUU held in a TFSA, how, precisely, do you derive the “Total MER” of 0.39%?
    Also, is the 15% withholding tax applied to both distributions and increase in value of the security?
    With thanks

  • Avatar Laura May 29, 2019, 2:45 pm

    Thanks for the article. I have not considered the tax differences between the RRSP and TFSA. Great next step when looking at investments

  • Avatar Dale Roberts May 31, 2019, 8:12 am

    Thanks for the go-to post. This is a biggie as you write. Folks doing everything to lower fees (a staple for success) and then many are not aware of the withholding that is significantly more than the MER and quite significant over time. This is not greatly advertised, ha.

    The Robo’s mostly will face this as well. They use those fund of funds or face some currency conversion charges. A few of ’em will set up US dollar accounts for specific purposes to hold US assets. Many Canadian retirees will hold US assets to fund and hedge their US trips – Snowbirds.

    Dale

  • Avatar Allan June 1, 2019, 9:10 am

    What are your thoughts on holding HXS in your TFSA? Wouldn’t that overcome the withholding tax obstacle?

    • FT FT June 2, 2019, 1:06 pm

      Hi Allan,

      I would hold off on Horizon’s swap-based products until CRA provides clarify on how they plan to tax them going forward.

  • Avatar Meeko June 2, 2019, 3:49 pm

    1. Just an update on VTI, Vanguard lowered the MER to .03% as of the end of April.

    2. Just to clarify that these modified MERs (that take into account taxes on distributions) are dependent on the amount of distributions each period. So if the distributions change, so does the modified MER; correct?

    • FT FT June 3, 2019, 9:05 am

      Thanks for the update Meeko!

  • Avatar Garth June 7, 2019, 8:52 pm

    Am I reading the holding details correctly in this situation?
    iShares XUS/XUU is about 78% IVV
    Vanguard VFV on the surface doesn’t show that it is primarily holding an underlying US listed ETF.
    If my understanding is correct, it is obviously much more efficient to hold VFV in a registered account.
    It seems to read similarly for Vanguard’s other international etf’s as well. VE etc.
    Thanks
    Am I in fact

  • Avatar strela July 11, 2019, 12:44 pm

    After reading this article and realizing that ETFs have additional cost in FWT I started looking into the TD eSeries if they have FWT as well. I was looking at the RRSP account in the comparison between the ETFs and the TD Index funds. Based on your table above for RRSP accounts the VGRO is 0.46% and XGRO is 0.41% respectively. These percentages come in line with the MERs for the TD index funds (0.35% for TDB902 and 0.51% for TDB911). However, the CCP in this article https://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/ states that the TD funds real expense is 0.65% and 0.84% for TDB902 and TDB911 respectively. This would make an average MER of 58% for asset allocation of 25% for each of CND, US, Intl equities and bonds, which is still more expansive than the ETFs. Are my assumptions correct? Please let me know. Thanks!

    • FT FT July 12, 2019, 9:22 am

      Hi Strela, yes you are correct. TD funds would have FWT added on top of the stated MERs.

  • Avatar Alan July 26, 2019, 10:09 pm

    Are the etf trailing returns on morningstar.ca net of fwt? Thks.

    • FT FT July 27, 2019, 7:13 pm

      It would be challenging to calculate returns net of FWT due to different percentages for different accounts. I would assume no.

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