My Nerdy Life

Investing Part 3: RRSP or Non-Registered or TFSA, Where Should Your ETFs Go?

Okay, so you’ve made the wise decision to invest your money, and you’ve even got some ideas for what ETFs you want to buy, so which account should you use?

“It depends.”

Phew! Dodged that bullet, now lets talk about puppies and beaches and other more fun things.

Well that’s what I wanted to do, and I’ll be the first to admit I’ve been avoiding opening this can of worms because they’re so many variables. That said, I’d rather spend some time to work through portfolio asset optimization than leave money on the table for the taxman.

Highlights

• If you have the contribution room, dump all your ETFs into your TFSA
• If you need to withdraw your funds soon, you may want to avoid RRSP (with the exception of the Home Buyers Plan)
• If using TFSA & RRSP & Non-Registered, put foreign ETFs in tax sheltered accounts and Canadian ETFs in Non-Registerd accounts

If you missed it, check out the other posts in this series:

• Investing Part 1: $1 Saved is $1.07 Earned!
• Investing Part 2: ETFs and Making Your Money Work, So You Don’t Have To!

This post took WAY LONGER than I originally anticipated, so please be gentle if I made some glaring errors/omissions. I’m also not a tax expert, and I’m learning about this as I go, so I’m tried to keep things simple. Alright, so let’s dive into rabbit whole of RRSPs, TFSAs, and Non-Registered accounts. To start, here are the assumptions I’m making:

• I’m not taking into account tax-loss harvesting or any other fancy maneuvers
• All ETFs will earn 5% compounded annually in internal capital gains (i.e., fund managers buying/selling on your behalf inside the ETF)
• Calculations will be based on the 2014 tax year rules
• Initial investment is $10,000
• Dividend rate reamins constant
• Dividends are fully reinvested annually
• An average marginal tax rate of 30% (probably higher than many people would actually pay)

Withholding Taxes

One of the more complicated and difficult aspects to estimate is the effects of foreign withholding taxes on dividends. Typically most ETFs that hold foreign securities (i.e., stocks) are subject to a variety of taxes. Many of these taxes are deducted automatically and you never see those appear anywhere beyond an ETF’s financial reports, and even then it can be tricky to figure out where the taxes are going and who is collecting them. Fortunately, the good folks over at Canadian Couch Potato have done a lot of the grunt work to try and calculate what impact this can have on your investments.

Generally, for us Canadians, ETFs will fall into one of the following categories:

• (1) Canadian-listed ETF that holds US or non-US international stocks directly – Level 1
  • PDF
• (2) US-listed ETF that holds US stocks – Level 1
  • VOO
  • VB
  • VO
• (3) US-listed ETF that holds non-US international stocks – Level 1 & Level 2
  • VGK
  • VEA
  • VWO
• (4) Canadian-listed ETF that holds a US-listed ETF of US stocks – Level 1
  • VUN
• (5) Canadian-listed ETF that holds a US-listed ETF of non-US international stocks – Level 1 & Level 2
  • XEC
  • VDU

The basic premise is that there are 2 levels of withholding taxes:

• Level 1: If is a Canadian-listed ETF holds international/US stocks directly, you will pay those countries a withholding tax
• Level 2: If it is a US-listed ETF that holds international stocks, you will pay the foreign country withholding tax on top of paying the US withholding tax

I like the layover analogy that Canadian Couch Potato uses: Your ETF will pay taxes in every country that it touches down in. If your international ETF (e.g., VDU) has a layover in the US, you will pay Level 1 & Level 2 taxes. If your international ETF has a direct flight to Canada, you will only pay Level 1 taxes.

All that said, keep in mind these withholding taxes ONLY apply to dividends! So for many people, this is actually quite a small amount of money. The US charges a 15% withholding tax on dividends, so on a $10,000 investment earning 2% dividends ($200), you’d be paying $30 (15% of $200) in withholding taxes.

As an added consideration, different accounts (RRSP, TFSA, Non-registered/Taxable) will also have different affects on the withholding taxes:

For a more detailed look at withholding taxes check out the white paper found on Canadian Couch Potato.

Capital Gains Taxes

Next up are capital gains taxes. These will have the most impact on your earnings, and are far more significant than withholding taxes. Here’s how they breakdown for different accounts:

• RRSP: No taxes are paid on capital gains until you withdraw from the account. Upon withdrawal, the total amount of the withdrawal is 100% taxable at your marginal rate regardless of where the money came from (e.g., capital gains, dividends, distributions, magical investing fairies).
• TFSA: No taxes are paid at any time for capital gains. It does not matter if they are foreign or domestic, anything you withdraw from the account is 100% tax free!
• Taxable: You will pay tax at the marginal rate on 50% of any capital gains from Canadian ETFs holding Canadian stocks. Capital gains from ETFs holding foreign stocks are 100% taxable at your marginal rate.

Withdrawal Taxes

This is where you have to be careful and make sure you have an exit strategy for each account. TFSAs have no taxes on withdrawal, so in all scenarios it will give you the biggest yield. RRSPs can be a powerful way to maximize compound growth by deferring your taxes until withdrawal. That said, this is only effective if you withdraw when your marginal rate is lower.

Combining Withholding and Withdrawal Taxes

Alright, so now lets combine the effects of the withholding taxes and the withdrawal taxes. In these examples I assumed a 30% average marginal tax rate (combined provincial/federal), which is most likely a bit on the high side for a lot of people, but let’s run with that anyway. I also assumed a fairly conservative 5% annual growth.

VOO (Category 2, US-listed ETF holding US stocks)

(Current ER = 0.03%; MER = 0.05%; Dividend Yield = 1.98%)

For example, let’s look at VOO (Category 2, US-listed ETF holding US stocks):

If you invested $10,000 and reinvested any dividends/capital gains/distributions annually, after 20 years your account balances would look like this:

• RRSP: $38,168
• Taxable: $25,699
• TFSA: $36,133

Here’s the math I used to get the principle after 1 year:

RRSP Principle = Dividends + Cap Gains – MER

= (1.98% x $10K) + (5% x $10K) – (0.05% x ((Dividends) + (Cap Gains)))

= $10692

Taxable Principle = Dividends + Cap Gains – Dividends Tax – Cap Gains Tax – MER

= (1.98% x $10K) + (5% x $10K) – (30% x Dividends) – (30% x (Cap Gains)) – (0.05% x ((Dividends) + (Cap Gains)))

= $10483

TFSA Principle = Dividends + Cap Gains – Level 1 Withholding Tax* – MER

= (1.98% x $10K) + (5% x $10K) – (15% x (1.98%-0.05%) – (30% x (Cap Gains)) – (0.05% x ((Dividends) + (Cap Gains)))

= $10663

*Level 1 Withholding Tax = 15% x (Dividend Yield – MER)

The calculations are then repeated annually using the new principle values.

On the surface, the RRSP looks like the clear winner, but those are the balances inside the accounts. Now if you actually withdraw those funds and put them into your normal bank account, it looks like this:

If you withdraw your money after 20 years you’d have this much money in your pocket:

• RRSP: $26,718
• Taxable: $25,699
• TFSA: $36,133

RRSP After Tax Withdrawal = Principle – (Principle x Marginal Tax Rate)

= $10692 – (Principle x 30%)

= $7484

Taxable After Tax Withdrawal = Principle

= $10483

TFSA After Tax Withdrawal = Principle

= $10663

The calculations are then repeated annually using the new principle values.

Whoa! Suddenly, things look very different when the taxman (CRA) takes his cut. But, if you wait to withdraw when you have a lower marginal rate, say 15% in year 19 and 10% in year 20:

Now things are looking better and your pocket got a lot fatter:

• RRSP: $34,351
• Taxable: $26,301
• TFSA: $36,133

This is why a thoughtful exit strategy can make a substantial difference in your net earnings.

The calculations are the same as above, but using a 15% rate for year 19 and a 10% rate for year 20.

XIC (Canadian ETF of Canadian stocks)

(Current ER = 0.05%; MER = 0.1%; Dividend Yield = 2.51%)

Now lets see what things look like for XIC (Canadian ETF of Canadian stocks, so no withholding taxes):

Note: The TFSA and RRSP are identical in this case, so the lines are on top of each other.

• RRSP: $41,714
• Taxable: $34,265
• TFSA: $41,714

Here’s the math I used to get the principle after 1 year:

RRSP Principle = Dividends + Cap Gains – MER

= (2.51% x $10K) + (5% x $10K) – (0.01% x ((Dividends) + (Cap Gains)))

= $10740

Taxable Principle = Dividends + Cap Gains – Dividends Tax – Cap Gains Tax* – MER

= (2.51% x $10K) + (5% x $10K) – (30% x Dividends) – (15% x (Cap Gains)) – (0.01% x ((Dividends) + (Cap Gains)))

= $10635

TFSA Principle = Dividends + Cap Gains – MER

= (2.51% x $10K) + (5% x $10K) – (0.01% x ((Dividends) + (Cap Gains)))

= $10740

*Eligible Canadian Dividends are calculated using 50% of the marginal rate

The calculations are then repeated annually using the new principle values.

 

The effects of the taxman are less prominent here due to the favourable nature of how Canadian dividends and capital gains are taxed. The rates for Canadian dividends  (I assumed 12%, which is about middle of the pack) are quite a bit lower than for foreign dividends, and Canadian capital gains are only taxed at 50% of the marginal rate.

• RRSP: $29,200
• Taxable: $34,265
• TFSA: $41,714

RRSP After Tax Withdrawal = Principle – (Principle x Marginal Tax Rate)

= $10740 – (Principle x 30%)

= $7518

Taxable After Tax Withdrawal = Principle

= $10635

TFSA After Tax Withdrawal = Principle

= $10740

As with VOO, there is certainly a bump in after tax earnings if your marginal rate is lower, but the difference is smaller due to the favourable tax treatment.

• RRSP: $37,543
• Taxable: $34,547
• TFSA: $41,714

XEC (Category 5, Canadian-listed ETF that holds a US-listed ETF of non-US international stocks)

(Current ER = 0.25%; MER = 0.27%; Dividend Yield = 1.64%; ETF Foreign Withholding Tax = 8.97%)

Now let’s look at XEC which is a Canadian-listed ETF that holds a US-listed ETF of non-US international (emerging) stocks.

The tax treatment on the principle for XEC is the same inside of an RRSP or TFSA:

• RRSP: $32,183
• Taxable: $22,826
• TFSA: $32,183

Here’s the math I used to get the principle after 1 year:

RRSP Principle = Dividends + Cap Gains – Level 1 Withholding Tax* – Level 2 Withholding Tax** – MER

= (1.64% x $10K) + (5% x $10K) – (8.97% x 1.64%) – (15% x (1.64% – Level 1 – 0.25%) – (0.27% x ((Dividends) + (Cap Gains)))

= $10601

Taxable Principle = Dividends + Cap Gains – Level 1 Withholding Tax – Dividends Tax – Cap Gains Tax – MER

= (1.64% x $10K) + (5% x $10K) – (8.97% x 1.64%) – (30% x Dividends) – (15% x (Cap Gains)) – (0.27% x ((Dividends) + (Cap Gains)))

= (1.64% x $10K) + (5% x $10K) – (30% x Dividends) – (30% x (Cap Gains)) – (0.27% x ((Dividends) + (Cap Gains)))

= $10421

TFSA Principle = Dividends + Cap Gains – Level 1 Withholding Tax – Level 2 Withholding Tax – MER

= (1.64% x $10K) + (5% x $10K) – (8.97% x 1.64%) – (15% x (1.64% – Level 1 – 0.25%) – (0.27% x ((Dividends) + (Cap Gains)))

= $10601

*Level 1 Withholding Tax = ETF Foreign Withholding Tax x Dividend Yield

**Level 2 Withholding Tax = 15% x (Dividend Yield – Level 1 – ER)

The taxman sure likes to get greedy on these international ETFs:

• RRSP: $22,528
• Taxable: $22,826
• TFSA: $32,183

Making it all so important to be mindful of your marginal rate upon withdrawal:

• RRSP: $28,965
• Taxable: $23,338
• TFSA: $32,183

XBB (Canadian ETF of Canadian bonds)

(Current ER = 0.3%; MER = 0.33%, Dividend Yield = 2.94%)

I include this one for the sake of comparison, since the capital gains (and taxes) will be far less significant. This means it becomes more important to consider the taxation of the dividends/distributions. I assumed only a 1% annual growth for this ETF.

Principle after 20 years:

• RRSP: $20,274
• Taxable: $16,595
• TFSA: $20,274

The calculations are the same as for XIC but using 1% annual growth.

Withdrawal after 20 years:

• RRSP: $14,191
• Taxable: $16,595
• TFSA: $20,274

Withdrawal after 20 years:

• RRSP: $18,246
• Taxable: $16,790
• TFSA: $20,274

Here’s a summary of the numbers in one handy table:

Just for fun, I also made a table which compares the differences between your RRSP and TFSA balance, as well as between your Taxable and TFSA balance:

I compared against the TFSA because in every scenario it beat out the RRSP and Taxable accounts. This is entirely due to the lack of tax on capital gains and despite the fact that withholding taxes are not recoverable.

Lastly, I made a table showing the total net return on the original $10,000 principle, which assumes all ETFs (except for bonds) had 5% annual capital growth gains:

I should note, that none of these take into account the growth/appreciation of the overall stock market. This last table suggests your best returns would be in XIC, BUT that assumes the Canadian market will grow at the exact same rate as all the others and no rebalancing is done, which is extremely unlikely over a 20 year span. In fact over the last 10 years, the US market has eclipsed the Canadian market by ~20-30%. Ideally, you should be rebalancing to take advantage of dips in the markets and maximize returns. Really this table just shows which ETF has the most tax-efficient advantage assuming all other things are equal.

So What Does it All Mean?

Now that we’ve gone through the numbers, it’s time to figure out where to put everything. If you’re only investing in a TFSA, then just dump everything in there as it will give the best results.

Long Term (>20 years)

If you’re using multiple accounts here are some possible combinations:

TFSA & RRSP & Taxable

• TFSA
  • XBB
  • XEC
• RRSP
  • VOO
• Taxable
  • XIC

TFSA & RRSP

• TFSA
  • XBB
  • XEC
  • XIC
• RRSP
  • VOO

Short Term (<5-10 years)

If you plan on withdrawing your investments in a shorter timeframe, it may be best to skip RRSP altogether unless you now have a significantly lower marginal tax rate when you withdraw. If you qualify for the Home Buyers Plan, then the RRSP could be a good strategy.

TFSA & Taxable

• TFSA
  • XBB
  • XEC
  • VOO
• Taxable
  • XIC

For some additional ideas, check out this post. If you’re interested in playing around with the spreadsheet that I used to create these numbers/graphs here it is: ETF Tax (I warn you it’s messy). I entirely expect that I missed something or goofed with these calculations, so I invite constructive criticism/corrections for any of the above. Can any tax-savvy people confirm/deny if I’m roughly on the right track?

If you missed it, check out the other posts in this series:

• Investing Part 1: $1 Saved is $1.07 Earned!
• Investing Part 2: ETFs and Making Your Money Work, So You Don’t Have To!

Disclaimer: I do hold some of these investments, but I do not receive any form of endorsement or compensation for writing this article. I was not solicited to write this article in anyway, and provide this information on a voluntary basis. I hold no formal financial accreditations, so please consult a financial professional and ensure you understand the risks before making any investment decisions.