Which ETFs are the most tax efficient for Canadian investors? – Moneysense

Lime that as a victory for Canadians. Between the tax -free savings account (TFSA), registered pension savings plan (RRSP) and First Home Savings Account (FHSA), Canadians have sufficient room to protect profit against the Canada Revenue Agency (CRA). These registered accounts offer more flexibility and contributing space than Americans with similar 401 (K) and Roth IRA plans, and they can go a long way if you use them wisely.

That said, whether it is windfalls or diligent savings, some Canadians manage to maximize their registered accounts. As soon as that happens, and until New Room opens in January, the challenge becomes how you can prevent more from your investment income and wins that a non-registered account is taxed.

Some listed funds (ETFs) are better than others for this. Here is a guide for how ETF tax efficiency works in Canada and which types of ETFs work best in taxable accounts.

The ABCs of ETF tax levy

In short, ETF taxes work a lot as the taxes on shares or bonds, because most ETFs are only collections of those underlying investments. If you have ever received a T3 or T5 slip, the categories will look known.

The easiest way to see how it works in practice is to check the website of the ETF provider for a tax breakdown. We will walk through an example with the help of the BMO Growth ETF (ZGRO), a globally diversified ETF of asset allocation with approximately 80% shares and 20% fixed-income income.

If you are scrolling to the ‘Tax & Distributions’ section on ZGRO’s Fund page, you will see a table that breaks down the composition of distributions per year. The most recent data for 2024 show that the ETF has paid $ 0.467667 per unit in total distributions, consisting of different tax categories:

• Eligible dividends ($ 0.082884): These are usually paid by Canadian companies and benefit from the dividend tax credit, which reduces your effective tax rate.
• Other income ($ 0.047890): This usually includes interest income of the bonds in ZGRO. It is fully taxable at your marginal tax rate, just like the salary or rental income.
• Capital profits ($ 0.157617): Often from ETF managers who reinstalled the portfolio. Although it is not always avoidable, only 50% of a power gain is taxable, which mitigates the tax hit. You will also have to pay this yourself if you sell ETF shares for a power gain.
• Foreign income ($ 0.169810): This comes from dividends paid by non-Canadian companies in the ETF. It is also fully taxable as normal income. Even worse, 15% is usually deducted from the source (visible as the “foreign tax -paid” line of – $ 0.018009) and can be restored or not, depending on the account type.
• Return from CapitaL ($ 0.027475): This is essentially part of your own money that comes back to you. It is not taxable in the year received, but it reduces your adjusted cost basis. This means that you ultimately pay taxes when you sell the ETF and achieve added value. Used correctly, this can smooth out distributions, but it can also blow up the yield figures.

All these are taxed differently, making ETFs such as ZGRO difficult to manage in a non-registered account. In a TFSA or RRSP you can ignore this tax complexity because nothing applies. But outside of registered accounts you must accurately report this, which can mean more work during tax time.

ZGRO is generally still a strong choice – it is diversified, affordable and well constructed. But for Canadian investors are aimed at tax efficiency, there are cleaner options. ETFs such as ZGRO are the most logical in a registered account where you don’t have to worry about this messy tax mix.

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What is your goal: capital valuation or income?

Finding out which ETFs are more tax efficiently starts with defining your objective. Are you investing for capital valuation or are you trying to regularly generate income from your portfolio?

If your goal is capital growth and you do not have to make regular recordings, for example, for pension income, the focus must be on ETFs that minimize or avoid distributions. As a result, the value of the ETF can grow due to share price profits instead of payouts that can postpone your tax burden.

A simple way to do this is by opting for growth -oriented ETFs. The Invesco Nasdaq 100 ETF (QQC), for example, offers exposure to American technical shares that usually do not pay high dividends, because they often reinvest the profit in research and development and expansion. QQC’s lagging yield of 12 months is only 0.42%, mainly foreign income. That level is low enough to minimize the tax resistance.

If you want to go one step further and completely avoid distributions, some ETF families are specifically designed to do that. A well-known example is the Global X Canada (formerly Horizons ETFS) Suite of Business Class, Swap-based ETFs. In simple terms, these ETFs use a different fund structure and derivative contracts to replicate exposure to shares synthetically, while distributions are avoided. This has worked well in practice. You could make a worldwide diversified stock portfolio using:

1. HXS: Global x S&P 500 Index Corporate Class ETF
2. Hxt: Global XS & P/TSX 60 Index Corporate Class ETF
3. HXX: Global x Europe 50 Index Corporate Class ETF

But there are considerations. These ETFs have seen their costs rise over time. In addition to the management costs, they also charge a SWAP allowance and have higher trading costs ratios than traditional index ETFs. This contributes to your costs to keep the fund. And because they trust Swaps, you will be exposed to the risk of a counterparty, which is the chance that the other party will not give birth to the derivative contract (often a large Canadian bank). That is unlikely but not impossible.

Another reservation is that although these ETFs are designed to prevent distributions, they cannot guarantee zero payouts. The distribution frequency is mentioned as ‘at the same discretion of the manager’, mainly because of the way in which fund accounting works. And there is always the risk that changes in tax legislation can change how these structures are treated, as happened in the past.

If you invest in a taxable account and give priority to postponing taxes, these ETFs are worth considering, but will open your eyes with your eyes.

Tax efficient income funds

Personally, I fall into the camp of only selling ETF shares and paying power gain tax when I need portfolio recordings. But I acknowledge that many investors (especially pensioners) have a strong psychological aversion to this. This behavior is known as mental accounting.