All-in-One ETFs and Changing Asset Allocation

May 27th, 2019 by Potato

So you liked the idea of all-in-one funds when they came out. You like-liked them. Finally, you love the idea of all-in-one ETFs and are going all-in. You’ve rounded off your asset allocation, and stuck it all in a single ETF. All new money that you save, you also stick in this one ETF.

Then about 20 years later*, your risk tolerance has shifted enough that a different all-in-one ETF is appropriate for you (e.g., VGRO now becomes VBAL).

How do you switch? What are the costs and trade-offs? This is one of the remaining sticking points for a lot of potential all-in-one investors (well, that and taming the need to tinker).

RRSP/TFSA: there are no tax issues to worry about, just go ahead and do it in one go. Costs a commission to sell (and depending on your brokerage, one to buy the new fund) — not material. Thanks for visiting, enjoy your all-in-one fund without any worries, you can skip the rest of the post. (And if you’re not sure how to buy an all-in-one ETF and invest and all that, check out the course to teach you just that).

Non-registered: it gets more complicated, as you might expect. When you sell a fund you’ll have to realize the gains (and thus pay tax). Turning over your entire portfolio at once might have some fairly large tax consequences. You can take an alternative approach, like buying a bond fund at some point (perhaps selling a bit of your all-in-one fund) to make a two-fund portfolio later.

That looks like you’ll trade simplicity today for a bit of a headache later, in either complexity at some point or a tax bill. That’s likely still a good move, though you’ll want to go in with eyes open on what the cost of maintaining simplicity is. Fine, let’s math it out to get an estimate.

TL;DR: doing a big switch-over in your non-registered account (like you might in a TFSA/RRSP) may end up adding something like double-digit basis points to your equivalent MER costs in realizing the taxable gains, which may push you towards more complexity later — which to be fair is a problem for future-you to deal with, and is still better than complexity all the way along, though it means at some point you’ll be pushed to learn how to rebalance).

Disclaimer: I did the spreadsheet and wrote the post on the train back from Montreal, so there may be errors. The cost ended up about double what I had guessed it would be, which may just mean the math is a caution to my intuition, and that people who want simplicity in a non-registered account might have to suck it up or look to the e-series funds, or it may be a sign there is indeed an error in here.

How big is your non-registered? Bear in mind that the benefit of simplicity will accrue to all your accounts, though the tax cost may only hit your non-registered. So if you’re planning on heading into retirement with a million-dollar portfolio, odds are that you may have most of that in registered accounts, so even a “big” tax hit to your non-registered may not be big in the context of the work you’re saving by using all-in-one funds for several decades in all your accounts.

Unfortunately, the switching cost is not a simple percentage that you can directly compare to an MER — it’s going to depend on future capital gains, your tax rates, etc. And looking at just the cost of switching an all-in-one fund will over-state things a bit, as you would still have to pay gains to rebalance a 3- or 4-fund portfolio when the time comes (or to sell it and use the money to live off of).

So how much is this going to cost? Let’s use a specific example to try to put some numbers to it. Let’s say you throw $5,000/yr into a non-registered account (remember, this is on top of what you’re saving in your TFSA/RRSP) and buy VGRO. Let’s say the market is well-behaved for the sake of our spreadsheets, and that investment grows at 6% nominal (your real return [which matters for most planning purposes] will be lower due to inflation, but for tax purposes nominal returns matter, and in this case this doesn’t include dividend/interest distributions — those we’ll say are part of our $5,000 annual [nominal] contribution).

20 years later, your risk tolerance has shifted enough that you feel VBAL is a more appropriate choice, and you have to switch over. Your VGRO at that point is worth ~$189k, with a cost basis of $100k. Switching in one big go means realizing a gain of ~$89k, so ~$45k gets added to your taxable income. That feels ouchy, though you’ve reset your cost basis so you’ll pay less tax when you eventually sell the funds for living expenses. Also remember that this is 20 years in the future with nominal dollars, so it’s not quite as bad.

If you have an income of $60k in today’s dollars (~$90k in 2039 dollars), the tax bill of the big bang approach would be (very roughly) $13k (in future dollars). That’s not all an incremental cost of using all-in-one ETFs though, as those gains have to be paid eventually if you don’t have a big switch.

There are some other options to spread the cost out and reduce it a bit, with just a bit of added complexity:

Option 1: spread it over multiple years. One of the issues with the all-in-one big-bang switchover is that it could add a lot of taxable income in a single swoop, which would then run up the marginal tax rates to add insult to injury (in this example, up to the ~38% bracket for someone normally in the ~30% one). You can pay less tax by just spreading the hit over a few years. That’s a bit of extra complexity, but not much. You could do it over a few years, which requires fiddling with your portfolio a few times, but timed right you can spend just a few days focusing on the trade to spread the tax hit over two years (by selling half in the last few trading days of December, then the other half in the first few trading days of the new year).

For a two-year hit, you would save about $600 in taxes as all the capital gain fits into the bracket you’re already in (so there’s also no added benefit to further spreading it out — other situations, like having more gains, may change that).

Option 2: break the simplicity. You can still get ~20 years of simplicity with an all-in-one fund, then sell just enough to buy enough of a bond fund to get you back to your desired asset allocation. You’ll be in for more complexity for the rest of your investing days, but by that point it may be worth it.

Math of that: Sell 25%** of your VGRO, buy a bond fund, and get your 60% overall stock exposure. Then you’d be paying about $3.3k on the smaller realized gain portion (again, nominal dollars).

Our counterfactual is investing in a 4-fund portfolio. In that case, you may be able to keep rebalancing by just buying bond funds with your new money each contribution. (We’ll ignore the potential differences in return from having progressively more/less in equities at different points than the all-in-one discrete route — though to be fair, that should also be open as part of option 2, where you just buy bond funds along the way and break the simplicity of the all-in-one fund earlier without having to realize any gains).

Then you start selling down, perhaps at a lower base income. For simplicity of modelling, let’s say that you want to sell enough to generate $10,000/yr in after-tax income (in 2039 dollars) for 20 years and it’s all in the lowest tax bracket. But because the cost bases will be different, we’ll have to sell different amounts of the portfolio. That is, the now-VBAL portfolio will need us to sell a bit less to get the income we need because with a freshly reset cost basis, it will start off almost all tax-free (but because you paid more in taxes in 2039, you’ll also have less to start with). Let’s also throw 5% nominal growth on that portfolio just to make my job modelling in Excel harder.

Big bang VGRO: take off $13.9k in taxes to start, then model growth, sell-off, and finally final value. In year 1 you have to sell $10,096 to get $10,000 after-tax (just one year of 5% growth to pay taxes on), and by the end you’ve collected $10,000 x 20 after-tax, and have $138.2k left (of which $89.3k is unrealized gains from the new growth).

Two-year VGRO: take off slightly less in taxes ($13.3k), so it comes out pretty similar: an ending value of $139.9k, of which $90.3k is unrealized gains.

Hybrid: Take off $3.3k in taxes for selling just a quarter of your VGRO, which leaves you with a higher unrealized gain as you start to withdraw your funds. To get $10k after-tax, you have to pull out $11.0k in the first year. By the end, the portfolio is worth $145.4k, of which $115.8k is unrealized gains.

4-fund alternative: here we’re assuming that you’ve never had to realize any gains, yet somehow made the same return as VGRO/VBAL. So when you start pulling your $10k/yr income out, you have to sell $11.1k in the first year pre-tax to get that. After 20 years of that, you’ll have $151.7k left, of which $123.3k is unrealized gains.

Then what happens with those unrealized gains can matter a bit. If you just discount them by 10% (half the lowest tax rate), then we find the after-tax value of the portfolio is $10.1k lower for the all-in-one user — the tax hit and lack of continued compounding does hurt, though some of the tax hit at the big-bang rebalance will be made up in later years as the unrealized gains did eventually have to be realized to generate income out of the portfolio. And if this point represented death where all gains are realized at once, then the bigger unrealized gains may push your estate up into a higher bracket, closing the gap further.

Again, it’s hard to put this into MER terms. An ending value that’s something like 7% lower after 40 years would be like 18 bp more in costs, which sounds higher than I was expecting when I started doing the math, honestly. Of course, I may be being overly fair to the 4-fund alternative’s ability to match VGRO’s growth without any selling to rebalance along the way — there likely would be some gains realized along the way. If you accept a 2-fund approach in the future (only selling a portion to buy bonds), the hit would be more equivalent to 10 bp. And you also have to consider how much of your portfolio is non-registered — here I’m considering just the non-registered portion, but if most of your money is in registered accounts (as most Canadians can expect to be the case) and you want to consider spreading that tax hit over a larger denominator, the MER-equivalent type hit might be less than a third of this.

As always, balance any costs against the value: the extra simplicity of an all-in-one fund is practically a no-brainer when the MER is only about 10-12 bp higher than a 4-fund portfolio. If it’s more like 30 bp when you add in the tax hit of a big-bang rebalance, then you may have to think about it a bit more (esp. when you can start getting into TD e-series funds at about that level and automate your purchases — though the all-in-one funds would still work in your registered accounts).

Edit May 27: to clarify, the tax hit is coming from a few sources. First is just realizing the gain and missing out on the ability to continue to defer taxes and compound the growth. Next is the fact that the gain is at a higher tax rate (I’ve assumed here that the hit comes while working, at a minimum of 30% tax rate, and higher for the “big bang” switch, while in retirement gains are realized at a 20% tax rate). So there’s a few factors mixed together in this scenario.

* – Why 20 years in all the examples? If we take the basic rule-of-thumb of basing your asset allocation on your age, that implies that you shift your allocation by about a percentage point per year, and the different all-in-one funds shift by 20 percentage points… Your own case will be your own case, though.

** – Why not 20%, which may be the intuitive first-guess answer? Because you’re selling part of your bonds, too. To get to an overall 60/40 split, you’ll need 75% in VGRO and 25% in straight bonds.

Freelancing Finances – Spreadsheet

May 14th, 2019 by Potato

I mentioned back in the guide to Canadian taxes for freelancers that I don’t use fancy accounting software for my side business, just a spreadsheet. A reader asked to see a sample of how such a sheet would look, and here we are.

TLDR: click here to download the template for Excel.

Click here to view the template in Google Drive (link set to make a copy, which may prompt you to log into your Google account — this one to view the template).

In brief, I like to lay things out into sections to help me keep track of my sources of income and expenses, and this is laid out that way. I can create a new tab for each year.

Everyone’s business and taste in spreadsheets will be different, so this may not suit you. For example, you may not have any inventory to track, or you may have many things to track rather than a single book to sell. In my case, I have a whole separate tab for direct book purchases (and postage) because I may have a hundred in a year (vs. only a few lines for consulting/editing/royalty/other income). And of course, I’m a small supplier, so I haven’t built HST tracking into this.

My One Big Tip is to remember what you’re going to use all this information you’re tracking and calculating in your spreadsheet for. Down the road, you will have taxes to report, so if you’re filling out a T2125, you’ll want to make life easier on yourself by making it clear how your personal tracking methods will map over to that CRA form. You might have other purposes though, such as tracking your own progress, planning your business, cash flow, etc., so you may also track things that aren’t relevant to your taxes alongside information that is, or calculate things in different ways for your own use.

While I’ve spread things out, you might want to track a single column of revenue and expenses (perhaps then with a note for each line). In the end revenue will all go on a single line, but it may be useful to you to see the different sources (and make it easier to cross-check bank accounts or invoices later if you need to double-check). Your own organization will have to make sense to you and your business; another example might be to organize revenue sources by provinces with different HST rates (if you collect HST). For the expense side again you can use a single big column, but different sections for your expense categories can make your life easier come tax time (esp. with notes about how things will work).

I have a net income for personal use calculation, and I note that it’s for personal use because the calculation for taxes will be different, and that’s not what it’s for in the snapshot on the spreadsheet. For example, I don’t include business-use-of-home expenses when looking at my side business income (they’re already in my personal budget that I need the income to pay for), and while only a portion of some costs (like 50% of business meeting meals) are eligible expenses for tax purposes, I consider the full cost when making decisions. You can create your own net income line to either line up with the tax calculation, or to include certain items for your own planning purposes.

When it comes to keeping receipts, I’ll either have a physical folder in my filing cabinet with paper receipts, or they will be electronic receipts that are either sitting in an email folder somewhere or downloaded to a folder on my computer. Likewise for invoices/sales — some have invoices, some are email notifications of income (e.g. royalty income, advertising income) that then shows up in a bank account, and some have other ways of tracking (e.g. WooCommerce for direct website sales). In all cases I want to make my reconciliation easier by having some indication of where to go to find the supporting documentation. Sometimes that’s an explicit note (this is in an email dated X) and sometimes it’s in my head based on the organization — all postage receipts are in paper in the physical folder, all direct book sales are tracked through WooCommerce unless otherwise noted, all consulting gigs have PDFs of invoices in a folder on my computer. So breaking the items up into groups in the spreadsheet works with this system.

And finally, be kind to your future self and leave helpful notes on things. If you have to look something up while filing your taxes, odds are you’ll need to know it again next year (e.g. “yes, every year you check and you can include insurance as a business-use-of-home expense (appropriately pro-rated)” or “the category names are dumb, ‘stationery’ doesn’t actually include stationery, that goes in ‘office expenses’, and I really need to see if the CRA needs a good technical writer who works from home.”) I’m not concerned about my notes fitting in the cells — I don’t generally print this out, so as long as I can see “note” I can then click on the cell to see it. You can also use the comments function if you like, or set up a separate notepad area of your spreadsheet — it’s your spreadsheet, make it work for you!

Anything to add? Anything wrong? Anyone have their own (sanitized) sheets to share?

Rest of the Guide to Canadian Taxes for Freelancers:

I’m not an accountant, and I’m certainly not your accountant. Tracking your finances and reporting your taxes is ultimately your responsibility, and this post & spreadsheet are provided as-is for education and entertainment without any guarantees. Further, remember that tax rules can change and may make this content even more useless.

Taxes and Investing: Orientation

April 4th, 2019 by Potato

This is not a detailed how-to post, instead this is a quick orientation to taxes and filing involved with investing.

First off, there are tax shelters: if you’re doing all of your investing inside an RRSP or TFSA, you don’t have any worries: other than any RRSP contributions (which you get receipts for) or withdrawals, you don’t have anything to report on your taxes. Not only are your investments growing tax free inside those accounts, you don’t have to do any detailed tracking or reporting.

If you’re out of RRSP and TFSA room and are investing in a taxable or “non-registered” account, you’ve got some things to know.

On timing: you’re likely not going to be able to file your taxes until April: some tax slips (i.e., T3s) aren’t due until the end of March.

You’re going to have the responsibility to learn about and report your situation for your taxes (and hey, self-promotion time, I’ve got a course that includes a great module on that). Things to watch out for:

First (and easiest) is income that gets reported on a T-slip. Dividends and interest payments. In this case you need to get a T3 or T5 from your financial institution or brokerage — if it didn’t come in the mail, be sure to log in to your account in April and look for an electronic version to download. It might also be auto-populated in the handy new myCRA feature that connects to your tax software of choice. Reporting this is a snap: you copy the amounts from each box on the tax slip into the corresponding box in your tax software for your return.

Second is interest or other income that did not get reported on a T-slip. The biggest culprit is savings accounts: your bank only has to send you a T-slip when the interest for the year is over $50, but every dollar of interest is taxable even if you don’t get a slip. You’ll have to go through your statements, add up those pennies of interest yourself, and then report it (look for line 121).

Third, and the one that seems to cause the most grief, is capital gains. You only report realized capital gains — you don’t have to pay tax or report when the value of your investments goes up, only when you sell it (or transfer it into a TFSA/RRSP, which is called a deemed disposition). You will get a tax slip in many cases (a T5008), but this will more often than not be wrong or be missing information. So this one you might choose to set aside in favour of your own calculation that you report on schedule 3 (and you’ll have to do this anyway to verify that your T5008 is correct unless you have a lot of faith in your brokerage). You’ll need to know your adjusted cost base (ACB) to report your gains, which requires tracking over all the years you’ve held the investment — this post and spreadsheet will help with that.

There are some other rare things to be aware of, for example if you have more than $100,000 CAD (cost basis) in foreign investments, you’ll have to fill out a T1135, which is separate from your overall tax return.

Tax software: While you can pay more for “premium” tax software that includes a “wizard” to guide you through reporting your investment income, it’s not necessary. The forms are included in all tax packages, including SimpleTax [affiliate link*], Turbotax standard/online, etc.

* – it’s pay-what-you-like, which includes free, so it’s weird to have an affiliate link, but if you do choose to pay and you use my link, I’ll get a portion.

And disclaimer: filing your taxes correctly is your responsibility, including verifying anything you read on a Potato-powered blog. Hire an accountant if you’re not sure — and note that I am not an accountant.

Swap-Based ETFs and Budget 2019

March 20th, 2019 by Potato

I’ve perhaps been one of the more paranoid bunch on the topic of swap-based ETFs. They offer some attractive tax benefits, particularly for high income earners, so some people are naturally excited by them, but I’ve been kind of ‘meh’ on them and haven’t included them in my various tables of model portfolio options (and not without a disclaimer). The benefit isn’t quite as large for people in middle tax brackets (which I believe is the core of my readership) vs high-income earners who love them, and there’s that ever-present legislative risk. Perhaps it’s because I owned units in some income trusts in 2006, but this seemed like one of those too-good-to-be-true bits of alchemy (international dividends into deferred capital gains! poof!) that was begging to be closed.

I don’t see details yet, but it looks like Budget 2019 is going to address it:

To make Canada’s tax system more fair, Budget 2019 proposes to:
• Prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.
• Improve existing rules meant to prevent taxpayers from using derivative transactions to convert fully taxable ordinary income into capital gains taxed at a lower rate. [page 209 of the English Budget 2019 PDF]

Horizons has a short note up on their site here.

If you don’t yet own any, perhaps wait a bit longer before making the switch from vanilla ETFs. If you do own them, for now, I suppose just wait and see specifically what happens with them. In the meantime, Ben Felix put up a good video on how the swap-based ETFs work.

Update: Thanks to Reddit user DavidsonWrath for pointing me to additional details, which are very dense legalese.

Meltdown RRSPs for Future GIS Recipients

February 22nd, 2019 by Potato

Retiring on a low income, particularly where you expect to get GIS, changes a lot of conventional wisdom about saving for retirement. An RRSP can work against you, as you face a high effective tax rate for withdrawals due to GIS clawbacks. For more on retiring on a low income, listen to the Because Money podcast with John Stapleton.

A while ago I showed you how to defer taking your RRSP deduction, but in most cases it’s not worth doing. Could the case of someone expecting GIS be an exception?

The scenario: someone in the lowest tax bracket (let’s use 20% as a nice round number) put money in their RRSP before hearing that it might not be a good move for them. They haven’t claimed the deduction yet, so should they defer taking it until GIS starts and they withdraw from their RRSP?

Option 1: Take the deduction right away. Let’s assume this person will be grossing up their RRSP contributions when taking the deduction to make things a little more comparable. So $1000 in the RRSP thanks to that (but only $800 if they had not taken the deduction or were using a non-registered account).

Over time with investment growth, they have $2,000 to withdraw. But now their effective tax rate is 70% (20% base rate plus 50% GIS clawback). So a $2,000 RRSP withdrawal turns into just $600 in spending power — less than the $800 in after-tax money they put there in the first place, despite doubling in nominal value!

Option 2: Defer taking the deduction. That means the “government’s portion” won’t be growing along with their funds, and isn’t there to gross-up the contribution, so to be comparable there’s only $800 in the RRSP to start. With investment growth doubling the value as before, that turns into $1,600 to withdraw in the future. They can then withdraw that, but have $800 in carried-forward deductions to use against it, so only $800 is left as taxable income. Again at a 70% effective tax rate on the taxable part, that leaves $1,040 to spend. In this case deferring the deduction did help compared to taking it right away.

Option 3: Bail out. If you haven’t yet claimed the deduction, another option is to just bail on the RRSP. Withdraw the following year, use the deduction to cancel that out (no time yet for growth to have happened, so the deduction is approximately equal to the contribution), and invest in a non-registered account (we’re assuming the TFSA is full). So you invest $800 in a non-registered account and again have it double over time to $1,600 (assuming all deferred capital gains for simplicity). Then in retirement you sell the investment. Half of the gain gets added to your income: so of the $1,600 total value, $800 is principal and tax free to spend; of the $800 gain $400 is taxed. At the 70% tax rate, that’s $280 in tax, leaving $1,320 to spend.

Conclusion: While this is a scenario where deferring the deduction works out better than taking it immediately, it really just underscores that RRSPs are terrible vehicles for people who expect to get GIS. You’re likely going to be better off just melting down the RRSP while you’re still working and investing in a non-registered account before retirement.

This was a quick back-of-the-envelope post, but my intuition at the beginning of the question was that bailing on the RRSP and using a non-registered account would be the better choice for someone expecting GIS in retirement. Please let me know if you have corrections to the math or assumptions.

Post-script: RRSP Meltdown. So this all suggests that if you had made RRSP contributions as a low-income earner expecting GIS in retirement, you could be better off melting down your RRSP while you’re still working. If you can withdraw those funds and pay tax at a 20% rate, then invest in a non-registered account, it may work out better paying a high tax rate on the growth than waiting and paying a high tax rate on the entire withdrawal (even if you get some further tax-free compounding). Proof left as an exercise for the reader.