ETF and MUTUAL FUND TAXES - How are you taxed on ETFs? - YouTube

Hi everyone and welcome back to the Independent Dollar, as we make our way through our February

Tax Tips & Updates series.

If this is your first time with us, we make weekly videos on Personal Finance topics in

a way that’s straightforward and easy to understand.

Today we’re focusing on understanding the taxes surrounding ETFs and Mutual funds.

We’re also going to look at ways that you can try to reduce your tax footprint, through

either a change in the structure of your investments, or where your investments are held.

When we think back to our most crucial investment decisions, most of the time we focus on the

underlying investments: How much should we invest in equities, real estate, fixed income?

Should there be more Canadian or less Canadian focus?

What has the cheapest fees or the best historical performance?

One crucial decision that is often overlooked is the tax treatment of investments.

Before we dive into it, let's take a quick look at some of the various taxes that may

result from income or gains earned within your investments.

For the most part, we think of paying taxes on the income you earn or when you sell and

investment, however your mutual funds and ETFs will distribute a combination of interest

income, dividends, and capital gains throughout the year.

A “dividend income” or “monthly income” product will have regular payouts, either

monthly or quarterly, as these products are meant to generate income.

Other products, such as US Equity funds or ETFs may not have regular payouts, but instead

will payout one large lump sum of all the dividends at the end of the year.

There is also a scenario, which we will discuss a a little later,

when comparing ETFs and mutual funds,

where there is an additional lump sum paid out to investors.

Interest Income is treated as regular income, meaning it is taxed just the same as your

regular salary is.

Someone who is sitting at the top bracket will be taxed at almost 54%.

Most dividend income, with only a few exceptions, will go through a dividend gross-up

and subsequent tax credit.

So a similar individual in Ontario at the top tax bracket, will pay closer to 40% in

taxes on the same amount of income.

Lastly, with capital gains, you are taxed on only 50% of what you made, so that would

effectively reduce your rate to approximately 27%

assuming you are sitting at the highest tax bracket.

As you can see, the various ways that your investments distribute income to you can have

an effect on the total amount of money you’ll have, after taxes.

Here are some quick tips on how you can reduce your tax footprint:

Tip #1 - Holding Your Investments in a Tax Sheltered Account

In Canada, those will be your various retirement accounts, such as RRSPs, RIFs, and LIRAs,

as well as the TFSAs, RDSP, and RESP accounts.

If you’ve maxed out the contribution room in both your TFSAs and RRSPs, or you’ve

made the decision to hold some of your money in non-registered accounts, you should be

selective as to which products you hold.

As we’ve seen previously, the tax treatment of interest income, typically found in fixed

income products such as bond funds/ETFs and GICs will be taxed at the highest level.

It might be wise to keep a larger portion of those investments in tax sheltered accounts,

while your equity funds or ETFs remain outside.

However, equity funds and ETFs may generate much more capital gains and dividends in the

long run, so there is a trade off in short-term versus long term taxes.

Tip #2 - Foreign Investments

At this point we’ve now established that you really should hold as much of your investments

inside a tax-deferred or tax-free account as possible.

What we haven't taken into consideration,

is the withholding taxes on foreign investments.

A withholding tax is a set tax amount or rate that a country will hold back from payouts

to clients who are investing from another country.

An example of this, is a Canadian who purchases a Global Equity fund.

The fund itself will invest in various stocks around the world, but whenever each of the

individual stocks pays out a dividend, the government will withhold a set percentage,

like 25%, back in the form of a tax.

Many countries have tax treaties set-up with their largest trading partners to help limit

the additional taxes, or have provisions for tax credits.

Canada has a treaty with the USA, where US stocks held within an RRSP will not be subjected

to withholding taxes.

This treatment though, does not extend to our other tax sheltered accounts, like your

TFSAs or RESPs, so the preference really is to hold those investments in an RRSP account.

However, where things start to change is with Canadian mutual funds and Canadian ETFs that

invest in the US.

These products are not exempt under the tax treaty and would therefore have to pay the

withholding tax.

A solution to this could be to purchase US listed ETFs instead of the Canadian ETFs investing

in the United States . As of right now, according to the Canada/US tax treaty, US

listed ETFs would be exempt from withholding taxes in your RRSP.

As for mutual funds, currently Canadian investors are restricted from purchasing US mutual funds,

so unfortunately there is not a similar solution available.

You’ve now moved as much of your investments into tax sheltered accounts, converted your

US equity mutual funds into US based ETFs, and allocated them from your TFSA to your RRSP

alongside your fixed income to take advantage of the favourable tax treaty and unfavourable

tax rate on ordinary income from your bond products.

Our third and final topic is special distributions.

Within a trust, such as an ETF or mutual fund, there are transactions of buying and selling

the underlying securities throughout the year.

This results in various capital gains or losses, and other investment income.

At the end of each calendar year, the funds will distribute these to unit holders of the

ETF or fund, and is known as a special distribution.

When comparing an ETF to a fund, there are distinct advantages to using an ETF to reduce

these “surprise” payouts which in some cases can be significant.

With the structure of mutual fund, as new investors purchase, or existing investors

redeem their holdings, there is a creation or destruction of units of the fund.

Most funds will keep a set amount of cash on hand to handle regular flows, but any drastic

moves will result in additional trades triggering either capital gains or losses.

On top of that, mutual funds for the most part are actively managed, which means the

portfolio manager is buying and selling securities throughout the year.

This will also add to the capital gains or losses of the fund.

How does that compare to ETFs?

ETFs are traded on an exchange with a limited number of units.

This means that they do not create or destroy units when someone is buying or selling like

a mutual fund does, nor do they need to invest extra capital or raise capital for investments.

On top of that, most ETFs are linked to the holdings of an index or set list of securities,

So the underlying holdings are not traded as frequently, again reducing the amount of

gains or losses being triggered, leading to smaller or non-existant year end distributions.

Now that last point is not entirely true for all ETFs.

We've have seen actively managed ETFs gain traction in the last few years.

They would suffer from the same tax issues as an actively traded mutual fund.

As well, there are mutual funds, called index funds, which mimic an index, so be cautious

of what you are purchasing.

Hopefully this video has been helpful in breaking down a topic that can sometimes be a little

can sometimes be a little confusing.

In all these situations, speaking with a licensed professional can help guide you to make the

best investment decisions

Stay tuned for our next video where we’ll be covering a few commonly unknown and expensive

tax rules you may not be aware of.

Thanks for watching and we’ll see you back here on Tuesday.