How to diversify my TFSA using ETFs

How to diversify my TFSA using ETFs

The Tax Free Savings Account (TFSA) is a gift to all Canadian investors.

I mean, who doesn’t love tax-free money?

Still got a bunch of cash in your TFSA?  That’s fine (I guess) but there are many other great things you can do with your TFSA here.

For years now, we’ve decided to use our TFSAs as a growing income-generation machine – investing in different Canadian banks, telco companies, pipeline companies and real estate investment trusts (REITs).  Thanks to that plan, and sticking to it, we’re generating thousands of dollars of tax-free money every year.  That money is growing every year to help fund our retirement nest egg.

Holding a number of Canadian dividend paying companies inside your TFSA may or may not appeal to you.  In fact, you might want to really diversify your portfolio, specifically your TFSA, using some low-cost Exchange Traded Funds (ETFs) like these fans/readers want to do:

Hi Mark,

I know you can’t offer advice but I’m simply looking for extra information…  I want to diversify my TFSA using ETFs.  I’m just not comfortable yet using individual stocks.  What would be examples of ETFs I could consider and why?

Hey Mark,

I’ve been stuck in paralysis by analysis mode for a few years now with $20,000 sitting inside my TFSA. I know I should get this money working for me since I keep an emergency fund in a savings account.  I own various ETFs in my RRSP (I like the benefits that come with these products) but I’ve heard there are tax issues with some ETFs inside my TFSA?  Is that true?  If so, is there any way I can avoid those tax issues?

Hi,

Wondering if you can help.  I need to diversify my TFSA to US equities through ETF holdings. What will be examples or recommended ETFs?  From reading your site, I saw you hold VYM which is in USD.  Will the dividends and capital gains of this ETF have U.S. withholding taxes if not held in your RRSP?  Your help is appreciated.

Wow, great questions from some savvy readers who are passionate about investing!

Well, I will certainly offer what I know folks but I can’t offer direct investing advice.  I can share what I’ve learned and thought about for my own portfolio in the past – and that includes the use of ETFs inside my TFSA.

Don’t let the tax tail wag the investing dog

First of foremost, what I’ve learned is, once you have a financial plan in place then picking financial products for that plan becomes a helluva lot easier.   Meaning:

  • What are you investing goals?
  • What are you investing money for?
  • What risks do you want to mitigate when it comes to investing?
  • How long is your investing timeline?
  • And so on and so on and so on….

Personally, if you’re putting products before plans you probably won’t be as successful as you could be.

With that out of way, what I’m implying by the bold font above is tax management should be down your financial to-do list after more important principles of investing are covered.  Those principles include keeping your financial costs low for as long as possible and considering diversification across your portfolio.  After you’ve factored that in, then being tax-efficient is a good thing too.

Canadian-listed ETFs for the TFSA

Without further delays here are some of the ETF products I like and why, including listing some of the taxation concerns with ETFs inside TFSAs these readers have outlined.  My table below is not an exhaustive list of ETFs you can own in each category nor a detailed account about foreign withholding taxes but it does outline my thinking.

Type of Canadian ETF TFSA tax impact? Canadian ETF Examples General comments
Canadian equity None that I can think of!

Canadian-listed ETFs that hold Canadian stocks avoid taxation inside the account.  Basically, dividends and capital gains can grow tax-free and money can be taken out of the TFSA tax-free.

 

 

·        VCN

·        VCE

·        XIU

·        XIC

·        ZCN

 

You can also find some of my favourite Canadian dividend ETFs here.

I personally wouldn’t pay too much more than 0.5% MER for any Canadian ETF, or any fund for that matter.

There are many great choices out there but some ETFs have foreign withholding tax implications – money withheld by foreign governments before the dividends are paid to you.

U.S. equity (via Canadian ETF) This is where things can get tricky.

While the TFSA continues to provide tax-free growth…there is a wrinkle…

Canadian-listed ETFs that hold U.S. equities will have foreign withholding taxes applied, 15% on dividends received.

These are withholding taxes you cannot get back; they are not recoverable inside a TFSA as far as I know!

·        XUS (holds U.S. IVV)

·        VFV (holds U.S. VOO)

·        VUN (holds U.S. VTI)

 

Although losing 15% of your dividends is not a huge hit for some U.S. equity exposure, why do that if you don’t have to?

Consider this: once your RRSP becomes large enough, use your RRSP-dollar account to hold U.S.-listed ETFs (such as IVV, VOO, VTI, other) or U.S. stocks.  You won’t pay ANY foreign withholding taxes if you do that.

Quick Example:  the withholding taxes on VUN (inside TFSA) vs. VTI (inside RRSP) = 2% yield on VTI * 0.15% charged on VUN = 0.30% extra costs for VUN over VTI beyond the money management fee to run the fund.  Something to consider!

International equity (via Canadian ETF) This is where things can get more complicated when it comes to withholding taxes…

While the TFSA continues to provide tax-free growth…a double whammy exists for Canadian-listed ETFs that hold U.S. listed ETFs with international equities that pay dividends; this is additional withholding tax.

Again, international and U.S. withholding taxes are things you can cannot get back; they are not recoverable inside a TFSA as far as I know!

·        XEF

·        VIU

 

Recognizing this additional layer of foreign withholding taxes, I think if you’re going to focus on international equities inside your TFSA it makes sense to buy a Canadian-listed ETF that holds international stocks directly where possible (e.g. XEF, VIU).

That said, there are some great ex-Canada ETFs that regardless of the small hit associated with foreign withholding taxes; the TFSA can be a good home for them.

See more details below.

 

Savvy investors will probably realize two big things in the table above.

1. I didn’t list lots of details about international equities.  While the TFSA continues to provide tax-free growth for assets inside that account, you need to factor in the additional withholding taxes wrinkle depending upon the product you own. A second layer of U.S. withholding tax will apply when the Canadian ETF holds a U.S.-listed ETF of international stocks.  An example of that is the iShares product XEC.  XEC holds U.S.-listed ETF IEMG.  Vanguard’s VDU is another one.    

For a complete breakdown of foreign withholding taxes explained – few do it better than the Canadian Couch Potato in this post here.

2. I didn’t list any Canadian bond ETFs above.  It’s not because those are not considerations for investors.  Rather, given where bond prices are now; the fact that interest rates are expected to rise over time (who knows??), AND to maximize the benefit of the TFSA – tax-free growth and tax-free income – I think you should put growth or income products in there.  That’s just me!

What about ex-Canada ETFs inside the TFSA?  

In recent years both iShares and Vanguard have put out some great products to help investors diversify beyond Canada’s borders.  iShares has XAW and Vanguard has VXC in particular.

I’m a big (and growing) fan of these global ETFs that are ex-Canada because of three key reasons:

  • I get global exposure to thousands of stocks I could never afford on my own
  • They trade on the TSX so I don’t need to worry about currency conversion (to buy U.S.-listed ETFs)
  • They have low management fees.

While XAW is a bit cheaper than VXC (0.22% MER vs. 0.25% MER), both products provide excellent all-in-one stock solutions outside of Canada; investing in approximately 50% of the U.S. market and the rest in international markets.  For a one fund solution that does it all outside of Canada these are good ETFs to own.

For further reading about some ex-Canada investing solutions like VXC and XAW in particular check out this stellar post here by Dan Bortolotti.

While withholding taxes will apply to XAW and VXC I personally think the additional costs are a small price to pay for the global benefit.  This brings to the following…

What to buy and hold and where?

Related to my general comments above…unless your TFSA value is modest to large, say over $50,000, don’t sweat the withholding tax stuff.  While it will be more cost-effective/tax-effective to hold U.S.-listed ETFs in your RRSP and keep Canadian content like XIU, VCN and ZCN inside your TFSA; it’s not worth obsessing over.  Remember to buy U.S.-listed ETFs you need USD $$.  This means you’ll need to deal with currency conversion costs to convert Canadian money to U.S. dollars to buy those U.S.-listed ETFs; even for your RRSP.  If you want to avoid that mess or just keep things simple, just buy a few low-cost, diversified Canadian-listed ETFs that holds U.S. stocks and/or U.S. and international stocks and spread those funds across your registered accounts (TFSAs, RRSPs, RESPs) first before taxable accounts.  That should keep you plenty busy while growing your bank account as well. 🙂

Here are my concluding thoughts:

  • Use the TFSA for equities not bonds or cash.
  • Use the TFSA for long-term growth not speculation.
  • In a TFSA, I think Canadian-listed ETFs (that invest in Canada alone or in foreign equities) are good choices since using a U.S.-listed ETF inside your TFSA does not offer any tax advantage.
  • In a TFSA, if you’re going to own some Canadian-listed ETFs consider an all-in-one ex-Canada fund for simplicity OR if you want to focus on international assets then consider owning a fund that holds the international stocks directly since it will help avoid the double-whammy withholding tax exposure.

These are my opinions based on what I know.  Your mileage may vary!

Bottom line

All investors make trade-offs with stocks allocations, bond allocations and cash holdings.  There really is no perfect portfolio.  Don’t let anyone tell you otherwise.

So,you can definitely go with a few ETFs for your TFSA, or one fund for that account, or replicate a few funds across all your investing accounts, or more combinations.  Instead of being paralyzed by endless analysis, I would encourage you to use this post and other posts on my site as some ammunition to get on with your investing life.  Making some lower-cost, diversified ETF decisions for your TFSA is far better than making no decision at all.

My Own Advisor disclaimer – I’m not a tax pro, accounting whiz or fee-only financial planner – so while I believe all this information should be accurate it might be worth talking to a financial professional about your needs and tax implications with investing.  After all, it’s your money.  Choose wisely.  I hope this post helped!

Mark

Mark Seed is the founder, editor and owner of My Own Advisor. As my own DIY financial advisor, I've grown our portfolio to over $500,000 - but there's more work to do! Our next big goal is to own a $1 million investment portfolio for an early retirement. Subscribe and join the journey!

10 Responses to "How to diversify my TFSA using ETFs"

  1. Great points, especially about not using your TFSA for speculative investments. TFSAs are so flexible that you don’t want to destroy contribution room by having a speculative investment inside your TFSA go bust (plus speculative investing is just a bad strategy for the average investor anyway).

    We’re trying to max out our TFSA each year with the goal of having $1M in our TFSAs by age 55.

    Reply
    1. “We’re trying to max out our TFSA each year with the goal of having $1M in our TFSAs by age 55” – that would be HUGE Owen.

      I hope you get there 🙂

      Reply
  2. Great post (as usual) Mark.

    I hold XAW in my RRSP, as well as a Canadian equity fund and use my TFSA (like you) to hold Canadian stocks.

    A nice breakdown of some of the best ETF’s as well. I know you are a huge fan of ETF’s (and I am too) but I still hold RBC Canadian Equity Income Mutual fund CLASS D (lower MER), and although the MER is higher than a lot of the ETF’s, it has outperformed almost all similar ETF’s with lower fees I could find.

    Reply
    1. XAW is a great product for the RRSP, as is VXC. Smart man.

      Nothing wrong with mutual funds as long as they are lower-cost and for the fee, you’re getting the value for service 😉

      Reply
    2. I owned the RBC income fund a decade ago. It’s expensive with a MER of 1.04% with an objective stated as “To provide a high level of monthly cash flow and
      relatively tax efficient distributions consisting primarily
      of returns of capital, capital gains and interest income
      and to provide the potential for modest capital growth”.

      Reply
  3. The MER is high at 1.04%, but over the last 10 years, even AFTER factoring in that MER, it has still outperformed most most ETF’s that are comparable – 10 yr average return = 10.4%. I have been happy with it, so I kept it – and put the rest of my mutual funds into ETF’s.

    Reply
  4. Mark, I ageee with your conclusions. People to tend be concerned too much about foreign withholding taxes in the TFSA, which should be reserved for equities because of higher expected return of equities. Expected return far outweighs any concern about foreign withholding taxes in a TFSA, and as we cannot know which part of the world will have the best return going forward, it makes sense to put some of each – eg. 1/3 each of Canada, US, international markets.

    Reply
    1. I absolutely think the TFSA should be full of equities…but that’s just me. People fuss over withholding taxes but the reality is, that’s WAY down on the list of priorities for most investors. Thanks for your comment as always.

      Reply
  5. While globally neutral 2 fund solutions like VCN/VXC or VCN/XAW are outstanding choices, we’ve chosen to embrace the new Vanguard asset allocation 80%-equity VGRO because it’s automatically rebalanced for you, and includes emerging markets. The bond component is attractive because it includes US and International bonds, despite the principle that TFSA is the place for equities. We’ve had multiple ETFs in our TFSA over the accounts’ lifetime, but this is our approach, as retired couch potato index investors.

    Reply

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