Spring is the season for maple syrup, Easter bunnies...and taxes. If the traditional sugar shack meal and Easter chocolate are weighing you down, exchange-traded funds (ETFs) can help you reduce your tax bill. How can they help?
ETFs are tax efficient
First,an explanation of the taxation of funds - whether they are mutual funds or exchange-traded funds. Since they are trusts, they are not taxed as long as they distribute all investment income earned during the year to their holders: capital gains, dividends and interest. Instead, the holder must pay tax on this income.
The advantage of an index strategy
In addition to generating higher returns than the vast majority of "actively" managed funds, index ETFs trade significantly less in the securities they hold and therefore distribute significantly less capital gains annually, thereby deferring taxes. In fact, an index ETF can hold a stock in its portfolio literally for decades. An investor who holds that same ETF for the long term (some ETFs are over 20 years old) will have time to marry their children before realizing the bulk of the capital gains on their investment!
ETFs do not pass on capital gains triggered by other holders
Another important difference between ETFs and mutual funds is that ETFs can defer capital gains. When a mutual fund owner sells his or her units, the fund itself redeems them. The fund must then sell portfolio securities to generate the cash to redeem the units. The gains realized on the sale of these securities will be distributed to the holders at the end of the year, which will increase their taxable income. Note that the person who triggered these gains by selling his or her units during the year will not receive a taxable distribution (although he or she may have to declare a capital gain on the sale of his or her units; no one escapes this!)
In the case of an ETF, when the holder sells his or her units, they are purchased by another investor in the stock market, not by the ETF. Therefore, there is no gain to the ETF and no tax impact to the other holders. Of course, the seller will have to declare his own capital gain, as in the case of a mutual fund.
Realize your losses to reduce your taxes
Index ETFs can also take advantage of opportunities to crystallize tax losses without fundamentally altering the composition of the portfolio. The investor can then use these tax losses to recoup taxes paid on capital gains from previous years or to avoid paying taxes in the future.
How is this possible? Let's say you have a $50,000 investment in an ETF that is down 15% due to a market correction. You can sell this ETF and simultaneously buy another ETF that replicates a similar index (but not identical since this would be a "superficial loss" that would be refused by the tax authorities). You will have realized a tax loss of $7,500 (15% of $50,000) while keeping the asset allocation of your portfolio intact. For example, you can sell shares of XIU (iShares S&P/TSX 60 Index ETF) and replace them with VCE (Vanguard FTSE Canada Index ETF).
Allocation of ETFs among your accounts
The allocation of ETFs among your different accounts (RRSP, TFSA, regular account, company account) will also affect your after-tax return. For one thing, dividends, interest and capital gains do not have the same tax treatment. Thus, in general, it is better to hold the shares in a regular account (where capital gains are less taxed) than in a registered account where any withdrawals are taxable income.
On the other hand, foreign investments are generally subject to withholding taxes on dividends paid. These withholding taxes vary by country and by account type. For example, it is better to hold U.S. shares in an RRSP (where they are exempt from withholding tax) than in a TFSA (where the withholding tax will be 15%). An excellent reference tool in this area can be found on the BlackRock website.
The allocation of your ETFs among your accounts should therefore take these factors into consideration, as well as your investment horizon and the foreseeable evolution of your tax rate over time.
Alternatively, your financial advisor will be able to structure your portfolio properly and will work with your accountant if necessary.