One of the most common questions that we’re asked after people read our free eBook on DIY index investing using ETFs is:

“Ok, so I know what sort of asset allocation is appropriate for me and I’ve decided what ETFs I want to buy, but which ones belong in my RRSP, and which ones are better in my TFSA?”

This is often followed by something along the lines of:

“Can I even put any of this stuff in my RESP… and what is this alarming article that I read that foreign withholding taxes are going to take 15% of my returns?!”

The answer to these questions can be slightly complicated – so we created: 

The coolest how-to financial graphic of all time to guide your through ETF-placement processClick To Tweet

**Because some of the more minute details we discuss can be a bit intimidating when it comes to organizing your ETF Portfolio, you should always keep foremost in mind that as long as you are investing in low-cost ETFs within your RRSP and/or TFSA you are getting 95%+ of the benefits of index investing. You are paying very little [in] fees and are growing your nest egg much faster than most investors. This is simply a guide that allows you to get the cherry on top of the low-cost investing sundae – but if it seems more trouble than it’s worth, you should feel perfectly fine keeping it simple and enjoying your amazing ice cream and sprinkles – sans the time-consuming cherry. **

Maximizing Your Index ETF Returns
So How Much Will This Help Me – and Is It Even Worth It?

Our handy guide clearly illustrates what steps you need to take to protect your gains from the tax man, but you are likely wondering if it is worth it to bother paying attention to this withholding tax stuff.

This is impossible for me to answer on your behalf because what you’re really asking is:

“Is the time and energy that I’ll spend re-reading your graphic a couple of times and then re-shuffling my portfolio worth whatever I’ll save in foreign withholding taxes on my investments?”

And the answer is: “I’m not sure”.

It depends on what your time and energy are worth to you, as well as how large your account balance is. Depending on these variables it might be worth it or it might not.

Passionate index investors are quick to point out that it is best to focus on the parts of investing that you can control (and that trying to pick stocks that will outperform is almost always a waste of your time, energy, and money). In that context, you can absolutely save a few tenths of a percentage point in a way that is completely under your control — guaranteeing that you will keep more of the money you’ve earned. On the other hand, the economics teacher in me feels compelled to point out that everything has an opportunity cost. If the cost of the cherry on the top of this sweet sundae is that you are too intimidated to start index investing with ETFs, or that you start ignoring the massive forest of asset allocation in exchange for focusing on the single tree of withholding taxes – then IT IS NOT worth it for you.

Johnny Canuck’s Nest Egg

Let’s take a look at what I mean with an example:

If 27-year-old Johnny Canuck has a $30,000 nest egg that he wishes to invest for his retirement (we’re ignoring everything else about Canuck’s personal finance situation in the name of simplicity) and he has a high risk tolerance to go along with his long investment time horizon, then he might decide to set up a very simple ETF index investing portfolio in the following manner:

$10,000 Canadian Equities
$10,000 USA Equities
$10,000 International Equities

The decision at this level on what overall asset classes to put his nest egg into is probably going to be the biggest factor in how much money his investments will make over the long haul. Some experts might argue that Johnny should have a more conservative element to his portfolio such as 10-20% in government bonds. Johnny knows that as he gets closer to taking his money out to fund his retirement, he should have a larger and larger part of his overall portfolio dedicated to safe investments such as bonds; however, Johnny is comfortable with the large ups and downs of equities at this point in his life because he knows he won’t need to touch his investments for 30+ years.

The next decision for Johnny is which registered accounts he should open with his discount broker. Johnny doesn’t have any children, so the RESP option can be crossed off. He is not yet married, so he doesn’t need to confuse his situation with a spousal RRSP or similar considerations.

Mr. Canuck takes a look at our RRSP vs TFSA article and concludes that based on his current salary of $60,000 (before tax) per year, his career/retirement expectations, and having a large amount of available contrution room in both accounts, there is no massive advantage in choosing an RRSP over a TFSA or vice versa. If Johnny were making a relatively high salary such as $100,000, and expected to retire to an annual income of an inflation-adjusted $50,000, then the tax benefits of using his RRSP mean that he could ignore his TFSA until his RRSP was maxed out – no matter what the withholding tax implications. On the other hand, if Johnny was making $30,000 per year, generating a meagre RRSP tax return (all other things being equal) probably means Johnny would be best using a TFSA and ignoring the withholding tax journey we’re about to embark on.

Now that Johnny has made his asset allocation decisions, found out that he has lots of contribution room in both his TFSA & RRSP, and then realized that there is no clear winner in the battle of TFSA vs RRSP tax shelters, he uses our guide to select his specific index ETFs and decide where to place them.

Johnny would likely come to the following conclusions:

1) He purchases roughly $10,000 worth of the ETF VCN in order to get his Canadian equity. This is simple since VCN is very cheap and gives access to the whole Canadian market. VCN is listed on the TSX – so it is purchased in Canadian dollars. Because all the underlying companies within the ETF are Canadian, and the fund is listed on the TSX, there is no worries about foreign withholding tax. It’s good to go in the TFSA or RRSP – it won’t make any difference from a foreign withholding tax standpoint.

2) He purchases roughly $10,000 worth of the ETF VTI in order to get his USA equity. This is the most tax-efficient way of getting exposure to the US market IF Johnny puts VTI in this RRSP. If he had VTI in his TFSA, in a non-registered account, or used an ETF from the Toronto Stock Exchange that tracked US stocks (such as VUN) he would pay withholding tax on the dividends.

3) Johnny purchases roughly $10,000 worth of the ETF XEF in order to get his international equity. Johnny can purchase this ETF in Canadian funds because it is listed on the TSX. He chooses this ETF because it holds the foreign companies directly – thus cutting out one of our “border crossing” scenarios and a layer of withholding tax. It is worth noting that this ETF doesn’t invest in emerging markets, so Johnny would have to look separately for that sort of exposure if he really wanted it in his portfolio.

To figure out how much foreign withholding tax will slice away from Johnny’s returns, we multiply the ETF’s dividend yield of 3.39% by the foreign withholding tax rate (provided by the aforementioned white paper) of 8.04%, to get an overall tax drag of .27% on the gross returns. On Johnny’s $10,000 investment, this .27% hit to his annual returns would cost him $27. Not earth-shattering, but not totally inconsequential when it comes to compounded returns.

The Lazy Canuck’s Solution

Johnny wasn’t sure about all of this complicated stuff including:

  • Manually rebalancing his asset allocation each year
  • Transferring money into US Dollars
  • Getting exposure to the world’s emerging markets

Instead he asked his similarly lazy friends at Young and Thrifty if there was a simpler way to get most of the benefits without all of the work.

Here’s what we’d tell Johnny:

Alternatively Mr. Canuck, you could sacrifice some foreign withholding tax and MER in the name of keeping life simple and go watch a hockey game. You could keep $10,000 in VCN, and then put $20,000 worth of your money into the ETF VXC. This ETF basically gives you exposure to every market in the world outside of Canada’s in one fell swoop. It will automatically rebalance for you and you can purchase it in Canadian dollars.

Now, as with anything in life there is a price. Here are a few of the minor drawbacks:

  • Your asset allocation won’t be perfectly balanced as in the first example due to the fact VXC is roughly 54% US Equities and 45% International equities (1% “other”). This probably isn’t a big deal after all, the initial 33/33/33 split was somewhat arbitrary but it’s worth noting.
  • You will have to pay a slightly higher MER (roughly .10%) on this $20,000 than you did in our first example.
  • You will have to pay foreign withholding taxes on both the US dividend yield of the fund and the dividend yield of each of the international equities after they travel through the USA and get dinged by two layers of foreign withholding taxes. This means that you will pay roughly .4% more in foreign withholding taxes than you would in our first example when it comes to the $20,000 you invested in foreign equities.
  • Taking into consideration the higher MER and higher foreign withholding tax that you will pay, you’re looking at a drag of about .5% on the $20,000 that you would now have in VXC compared to the way we invested in the USA and international markets before. The $10,000 you invested in Canadian equities obviously costs you the same in both examples.

The overall price Johnny C will pay in dollar terms to keep his life simple is roughly $100. Once again, Johnny might not think that amount is substantial, but 30 years of compound growth might see that number grow to over $1,000 by the time Johnny pulls his money out to help fund his retirement.

If We Were Johnny C

Personally, the $100 on a $30,000 portfolio isn’t worth it for me to go with the more complicated solution. Here’s why:

  • I like the easy exposure to emerging markets
  • I hate the logistics behind Norbert’s Gambit. This is the process you have to go through in order to minimize currency conversion fees (which are likely much larger than the small amount of basis points we discussed in this article). Keeping my money in CAD is just easier for me. If you have an income stream in USD that would simplify matters a lot.
  • It makes re-balancing SUPER easy – a big deal for me.
  • I don’t have to worry as much about where to put which ETF thus deciding not to worry about minimizing foreign withholding taxes. For example, in our lazy man’s solution it doesn’t matter if I put either of my two funds (VXC and VCN) in my RRSP or TFSA.

Rules of Thumb for Ideal Placement of ETFs

  • Sweat the big stuff, not the small stuff. Get asset allocation right. Get TFSA, RRSP, and RESP right when it comes to your income tax situation. Foreign withholding taxes are the cherry on the investment sundae.
  • Figure out if avoiding [withholding taxes and currency conversion headaches] is worth it for you. If you’re like me and it’s not, then stick with CAD-listed ETFs. The small difference in MERs and foreign withholding taxes can make a major dollar difference on large portfolios, but for you it may not be worth the effort and complexity.
  • Bonds generate interest income – best to hold these in an RRSP or TFSA.
  • Canadian ETFs that have Canadian equities in them are a great option for your TFSA, a good option for your RRSP (but not if they take away room from a US-listed, US equities ETF), and a good option for a non-registered account if there is no room left in your RRSP, TFSA, or RESP.
  • If you want specific exposure to the US market and don’t mind doing Norbert’s Gambit or have a source of US income, then purchase US-listed ETFs that track the US market such as VTI – and put them in your RRSP – NOT your TFSA.
  • To boost your international index ETF returns to their maximum level, purchase a Canadian ETF such as XEF that holds companies directly instead of through US-listed ETFs (like VXC does).
  • Ask your accountant if any of your decisions will result in significantly increased tax preparation costs. This will probably only be the case if you have maxed out your TFSA and RRSP and are investing in a non-registered account.

A big thanks goes to the following authors for their original research on this topic:

The Value of Simple – John Robertson
This primer will help you be a tax-smart ETF investor – Rob Carrick
Making Smarter Asset Location Decisions – Dan Bortolotti
Put Your Assets in Their Place – Dan Bortolotti
Foreign Witholding Tax Explained – Dan Bortolotti
Foreign Witholding Tax Revisited – Dan Bortolotti
The Wrong Way to Think About Foreign Witholding Taxes – Dan Bortolotti
Foreign Witholding Taxes (White Paper) – Dan Bortolotti and Jonathon Bender

*Note from John Robertson: One of the reasons we talk so much about simplicity vs complexity in this foreign withholding tax issue is that your asset allocation gets more complicated too. After all, every dollar in your TFSA is yours to spend when you pull it out for retirement spending; but you must pay tax to get money out of your RRSP. If you replicate your portfolio across all accounts you never need to worry about this factor, but if you have $15,000 in your TFSA and $15,000 in your RRSP, and put $10,000 of US equity only in your RRSP, your US equity exposure is now effectively less than a third of your portfolio. John gets into how to make the adjustment in his upcoming course, but it is worth asking if this is a rabbit hole you want to go down for the sake of a few dozen basis points.

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