Tax-Efficient ETFs � RRSP Part #2

Moez Mahrez In a previous issue, we discussed in-depth, the features and tax rules of Registered Retirement Savings Plans (RRSP), Tax-Free Savings Account (TFSA) and Non-Registered accounts. For Canadian ETF investors, we also shed light on the types of ETFs that are most tax-efficient and least tax-efficient for each of those account types. Here’s a summary chart:

As part of our series on tax-efficient Exchange-Traded Funds, we will dedicate a few future issues in providing our readers with a set of ETFs we consider to be tax-efficient for different account types, starting with the RRSP for this issue. ETFs selected for each account type can be viewed as a sample portfolios or an idea generator for ETFs to include in your own portfolio. We have selected ETFs based on whether they;

1) Provide unique tax-advantages to the account in question,

2) Can help optimize a particular portfolio strategy or

3) Do not pose any particular tax-disadvantage.

Although the aim of these articles is to provide tips on making your portfolio tax-efficient, we emphasize that, at the end of the day, these tax considerations are secondary in the decision-making process of selecting investments. Readers should rather view these tips as a way to tweak their portfolios for efficiency and optimization in the long run.

ETFs For Your RRSP

As can be seen in the table above U.S. dividends earned in a RRSP from U.S. listed ETFs (or stocks), allow you to reinvest your dividends earned in full without getting taxed. The compounding effects can result in significantly higher returns over time considering that the withholding tax rate is 15%. A caveat to this however, is that since U.S listed ETFs trade in US dollars, investors should pay attention to conversion rates by brokers. One way to save significantly on exchange fees is by using the Norbert’s Gambit method by purchasing ETF DLR, then journaling to DLR.U, then selling for USD cash.

When it comes to Canadian-listed funds that hold U.S. equities or hold U.S. listed ETFs it is best to avoid them because U.S. dividend income is taxed on your behalf. Canadian-listed ETFs that pay dividends from Canadian companies, however, are a safe bet since dividends are also tax-sheltered. Here are our top candidates for ETFs with quality companies that pay a handsome dividend:

State Street SPDR Portfolio S&P 500 High Dividend (SPYD)

We like this ETF for its high yield component which works well in a RRSP. SPYD holds the top 80 companies in the S&P 500 based on dividend yield. Although this ETF purely screens for high yield and not other fundamentals like earnings quality and dividend sustainability and debt ratios, the companies held are still among the top 500 companies in the U.S. by market-cap. Another feature we like about SPYD is its equal-weighting of its holdings giving its smaller companies an equal chance to impress and larger companies less of a chance to disappoint. In addition, SPYD is uniquely able to do this at a very low MER compared to other equal-weighted funds. A point to consider for your total sector exposure is that financials and utilities take up about 50% of this ETF, which makes sense given its higher yield. Overall, we think this ETF has a place in a RRSP portfolio to capitalize on tax-free U.S. dividends at a low cost.

Vanguard Dividend Appreciation ETF (VIG)

Although this ETF pays a lower yield than SPYD, we believe in dividend growth as an investment strategy. Companies that have a track record of increasing their dividends, generally demonstrate stability, well-run operations and an aim to increase shareholder value. VIG’s top 5 holdings consist Microsoft, McDonald’s, Johnson & Johnson, Walmart and Pepsi, companies that have been generating shareholder value for decades. We think this fund is well-suited for a RRSP as it pays U.S. dividends and provides steady capital growth over time. It is a common notion that capital growth is best suited for a TFSA due to it being a tax-exempt account. However, this does not mean that because you eventually pay taxes on with RRSP withdrawal that capital growth is inefficient. Do not forget that the RRSP is tax-deductible and is tax-sheltered so its compounding power of reinvesting realized returns is significant over say a 10-year period.

iShares Core MSCI EAFE (IEFA) & iShares Core MSCI Emerging Markets (IEMG)

We have selected these two international equity ETFs for investors wishing to gain international exposure in their RRSPs. Both of these ETFs complement each other nicely as IEFA gives diversified exposure to developed economies like Japan, Europe and the UK, while IEMG does so for emerging market economies like China, Korea, Taiwan and India. The top 10 holdings of these ETFs include Nestle, Royal Dutch Shell, HSBC and Toyota for IEFA and Tencent Holdings, Alibaba and Samsung for IEMG. To sweeten the deal, both ETF provide these exposures at a relatively low cost compared to peer ETFs offering the same exposure. You might wonder why we chose U.S.-listed for international exposure. Canadian-listed international equity funds that hold international securities directly can work just as well, however U.S.-listed funds that hold international securities directly are tax-efficient only in an RRSP. In other words, if you need to purchase U.S. listed ETFs for international equity, it is best to do so in a RRSP.

iShares S&P/TSX 60 (XIU)

If you would like Canadian exposure for your RRSP, this is a cheap way to get broad Canadian exposure while earning a decent yield. The fund is large-cap concentrated and invests in the 60 largest companies on the Toronto Stock Exchange (TSX) giving investors some stability in their portfolio. In an RRSP, Canadian dividends do not get any special treatment and are taxed at withdrawal. We have included XIU on the list as it does not pose any disadvantages to hold in a RRSP and for the fact that most Canadian investors like to have at least some home exposure in their portfolio.

Final Thoughts

To sum things up, an RRSP is great for fully capturing the benefits of ETFs that are:

1. U.S. listed and pay U.S. dividends.

2. Canadian-listed and pay Canadian dividends.

3. U.S. listed or Canadian-listed and hold international securities directly and not through another foreign-listed fund.

Our picks are meant to bring to light tax-efficient ETFs for each account type that are also appropriate and well-rounded for the long-term investor. However, you may come across other ETFs you want to see in your portfolio that may or may not fit the tax-efficiency criteria, which is fine. We would also like to remind our readers that tax-efficiency should not be the sole criteria used in selecting investments. All considered, we think this list can be a good starting point and act as a guide for selecting tax-efficient ETFs for your RRSP. ETF investors interested in sharpening their skills can sign up for an ETF Mutual Fund Update membership at https://etffundupdate.ca. Access to the website includes recommended lists, investment tools and a monthly newsletter with insights and updates to the ETF and mutual fund universe. Canadian Money Saver members get an exclusive 25% discount off the annual subscription fee by using the code: CMS upon sign up.

Moez Mahrez, CFA,

Investment Analyst at 5i Research

Waterloo, Ontario