Aren’t GPS devices the best thing ever? You punch in your desired destination and they tell you exactly where to go. Then again, every so often, they’ll go wonky on you, insisting you turn on a street that doesn’t even exist, or sending you straight into a major traffic jam.
Just so with implementing asset location, as introduced in my last post. General guidelines can be useful when trying to understand complicated topics like tax-efficient investing. In practice, however, these rules of thumb can lead you astray – especially if you follow them blindly, without regard to what’s going on right around you.
For example, you’ll often hear that it’s wise to fill up your taxable accounts with Canadian equities first and global equities next. Sometimes, this makes sense, as the Canadian company dividends receive preferential tax treatment (and global stock dividends don’t).
But where do you live? Depending on your actual tax rate and which province or territory you call home, there may be times when this “Canada first” rule of thumb might be a thumbs-down idea for you.
Today, I’ll explain how to estimate the taxable dividends on the equity ETFs in my model portfolios. We’ll then review the taxes payable in 2016 on each of the ETFs for residents across Canada. I’ll wrap up with suggested taxable account asset locations for top-rate taxpayers in each jurisdiction.
By the way, all yields and MERs below are annual; I’ll skip repeating that every time!
The Vanguard FTSE Canada All Cap Index ETF (VCN) follows the FTSE Canada All Cap Index, which has a gross dividend yield of 2.88%. Once we deduct the fund’s MER of 0.06%, we end up with a taxable dividend yield of 2.82%. Although this may seem high relative to the other asset classes below, you’ll recall that the eligible dividends receive preferable tax treatment, resulting in lower taxes than if the dividends were treated as ordinary income.
So … remember that rule of thumb, suggesting higher-income earners should first hold Canadian equities in their taxable accounts before all other asset classes? This really only applies in jurisdictions with relatively low eligible dividend tax rates (generally below 35%). Otherwise, you may be better off first holding certain foreign equities in your taxable accounts, even though their dividends are fully taxable as income.
Source: FTSE Russell Index Fact Sheet as of July 31, 2017
The iShares Core S&P U.S. Total Market Index ETF (XUU) follows the S&P Total Market Index, which has a measly gross dividend yield of only 1.90%. After deducting the fund’s expenses of 0.07%, the taxable dividend yield drops to about 1.83%. Even though taxes are initially withheld on the foreign dividends, they are generally recoverable at tax time, when you will be fully taxed on the dividends after the fund’s expenses have been deducted.
For provinces or territories with relatively high eligible dividend tax rates (i.e. above 35%), U.S. equities may be a more tax-efficient first choice to hold in your taxable accounts, instead of the Canadian-first rule of thumb.
Source: S&P Dow Jones Index Fact Sheet as of July 31, 2017
The iShares Core MSCI EAFE IMI Index ETF (XEF) follows the MSCI EAFE IMI Index, which boasts an impressive dividend yield of 2.96%. As XEF holds the underlying stocks directly, any foreign withholding taxes are generally recoverable at tax time. Similar to U.S. equities, investors will be fully taxed on the gross dividends after deducting the product fees of 0.22%, for a taxable dividend yield of about 2.74%.
Although many investors love their dividends, this spellstrouble for taxable investors throughout Canada. As I mentioned in my last blog post, if you’re going to hold any equities in your RRSP accounts, international equities should be your first choice (and your last choice for taxable accounts). This is one rule of thumb that applies nationwide, since there is not a single province or territory where holding international equities in taxable accounts first is expected to reduce the tax bill.
Source: MSCI Index Fact Sheet as of July 31, 2017
The iShares Core MSCI Emerging Markets IMI Index ETF (XEC) follows the MSCI Emerging Markets IMI Index. With a gross dividend yield of 2.32%, it falls somewhere between U.S. and international equities.
As XEC doesn’t hold the underlying stocks directly, there’s one layer of unrecoverable foreign withholding taxes, with an estimated tax drag of 0.23%.
With fees of 0.26%, it’s also the most expensive ETF in my model portfolios. After deducting the fees and foreign withholding taxes, we end up with a taxable dividend yield of about 1.83% (which happens to be identical to the U.S. equity taxable dividend yield). This low yield may make emerging market equities even more tax-efficient than Canadian equities in many jurisdictions going forward (including Ontario, Manitoba, Quebec and Nunavut).
Source: MSCI Index Fact Sheet as of July 31, 2017
So, in summary, below is the expected taxable dividend yields on the ETFs in my model portfolios. (Remember, VCN’s dividend yield is taxed at the lower eligible dividend tax rate, while the remaining ETFs are taxed at ordinary income tax rates.)
| Exchange-Traded Fund | Gross Dividend Yield | Unrecoverable Foreign Withholding Tax | Management Expense Ratio (MER) | Taxable Dividend Yield |
|---|---|---|---|---|
| Vanguard FTSE Canada All Cap Index ETF (VCN) | 2.88% | – | (0.06%) | 2.82% |
| iShares Core S&P U.S. Total Market Index ETF (XUU) | 1.90% | – | (0.07%) | 1.83% |
| iShares Core MSCI EAFE IMI Index ETF (XEF) | 2.96% | – | (0.22%) | 2.74% |
| iShares Core MSCI Emerging Markets IMI Index ETF (XEC) | 2.32% | (0.23%) | (0.26%) | 1.83% |
Sources: FTSE Russell, S&P Dow Jones and MSCI Index Fact Sheets as of July 31, 2017. BlackRock Canada and Vanguard Canada
Now, to the good stuff. What are the optimal asset location guidelines where you live?
For that, let’s estimate which asset class has the lowest expected annual tax liability in each province or territory by calculating 2016 taxes payable on a $10,000 investment for a taxpayer in the highest marginal tax bracket.
To make the comparison a little easier on the eyes, I’ve included a second chart below that provides the optimal 2016 asset location order for taxable accounts. (I’ve only considered annual income and its tax ramifications here, since we cannot accurately predict your unique long-term, unrealized gains.)
| Province of Territory | Vanguard FTSE Canada All Cap Index ETF (VCN) | iShares Core S&P U.S. Total Market Index ETF (XUU) | iShares Core MSCI EAFE IMI Index ETF (XEF) | iShares Core MSCI Emerging Markets IMI Index ETF (XEC) |
|---|---|---|---|---|
| Alberta | $88 | $93 | $131 | $101 |
| British Columbia | $87 | $92 | $130 | $100 |
| New Brunswick | $95 | $103 | $145 | $112 |
| Northwest Territories | $79 | $91 | $128 | $99 |
| Prince Edward Island | $95 | $99 | $140 | $108 |
| Saskatchewan | $84 | $93 | $131 | $101 |
| Yukon | $69 | $93 | $131 | $101 |
| Manitoba | $105 | $97 | $138 | $106 |
| Nunavut | $92 | $86 | $121 | $93 |
| Ontario | $109 | $103 | $146 | $112 |
| Quebec | $111 | $103 | $145 | $112 |
| Newfoundland and Labrador | $113 | $96 | $136 | $105 |
| Nova Scotia | $116 | $104 | $147 | $113 |
Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada
| Province of Territory | Ordinary income (top marginal tax rate) | Eligible dividends (top marginal tax rate) | 1st | 2nd | 3rd | 4th |
|---|---|---|---|---|---|---|
| Alberta | 48.00% | 31.71% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| British Columbia | 47.70% | 31.30% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| New Brunswick | 53.30% | 34.20% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| Northwest Territories | 47.05% | 28.33% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| Prince Edward Island | 51.37% | 34.22% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| Saskatchewan | 48.00% | 30.33% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| Yukon | 48.00% | 24.81% | Canadian Equities | U.S. Equities | Emerging Markets Equities | International Equities |
| Manitoba | 50.40% | 37.78% | U.S. Equities | Canadian Equities | Emerging Markets Equities | International Equities |
| Nunavut | 44.50% | 33.08% | U.S. Equities | Canadian Equities | Emerging Markets Equities | International Equities |
| Ontario | 53.53% | 39.34% | U.S. Equities | Canadian Equities | Emerging Markets Equities | International Equities |
| Quebec | 53.31% | 39.83% | U.S. Equities | Canadian Equities | Emerging Markets Equities | International Equities |
| Newfoundland and Labrador | 49.80% | 40.54% | U.S. Equities | Emerging Markets Equities | Canadian Equities | International Equities |
| Nova Scotia | 54.00% | 41.58% | U.S. Equities | Emerging Markets Equities | Canadian Equities | International Equities |
Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada
So, there you have it: A few jurisdiction-specific rules of thumb to guide you along your tax-wise way. But, as with that GPS that usually takes you where you want go, you may want to take a good look around at your personal circumstances before blindly following anyone’s general directions – even mine.
