Canadian ETF for Smith manœuvre

[Le Barbu]

I want to implement the Smith manœuvre on january 2015. Which ETF would you pick between XIC, ZCN and VCN. They track the same index, same MER etc. My concerns are distribution (for tax propose). Tell me your choices with reasons.

Dont want individual stock btw

[RichMoose]

None of the above. Smith Manoeuvre's are tricky from an investment perspective because you need to ensure your interest remains tax deductible and meets the specifications that CRA requires. The only ETF I know of that meets the requirements is XDV. It generates income, has no REIT's or other forms of income funds, but it only tracks about 30 companies and comes with a higher MER. I am looking to implement a SM myself, researched it extensively, and have reached the conclusion that individual stocks is the best way to go. If you start by looking at the holdings of CDZ (the Canadian Dividend Aristocrats ETF), you can find quality stocks that pay increasing dividends. The trick is to buy in chunks of at least $1000 (maybe more) of each stock at a time. Try and build a portfolio of more than 10 stocks for some diversity. Create a separate investment account just for your SM and make sure it doesn't become too big a piece of your portfolio (not a problem for you I think).

An awesome, informative website that is sort of a weak MMM for Canadians: http://www.milliondollarjourney.com/the-smith-manoeuvre-resource.htm

And I'll specifically point you here for the ETF issue: http://www.milliondollarjourney.com/why-i-dont-use-a-dividend-etf-for-my-leveraged-portfolio.htm

[Le Barbu]

TuxedoEagle, thank you to comment. It's really helpful to get someone else opinion to set my mind. MMM readers from Canada are only a few % so...

I already went through MDJ threads, so everything is set to proceed on January 5th. I just wait for 2015 to skip the hassle of tax filling for spring of 2016. In fact, I will not set a complete (real) SM. I just want to buy a 100k$ chunk and then, capitalize the interests and transfer the dividends in my checking account. The LOC is ready (never used and no plan to use it unless to invest or in case of real big emergency). The separate checking account is open and ready, I drawn my "Flow Chart" etc.

I also read all CCP articles concerning Canadian ETF and tax tips. From what I understand, when you decide to work with ETF in taxable account, and especially when it's with borrowed money, there is some details to know. ROC will decrease ACB; capital gain/share will increase ACB etc. It's still manageable since you know where to get information, how to fill tax papers, decrease the loan if needed.

FYI, I held some individual stock in the past but I prefer to stick with broad index ETF and that's why I just try to pick the best for my situation. I will give you more details I it help.

My RRSP : 280K, 30%ZCN, 30%VTI, 10%VBR and 30% VXUS
Wife RRSP : 160K , 35% ZCN, 35% VTI and 30% VXUS
RESP : 70K, 35%RBF556, 35% RBF557 and 30% RBF559
Total : 510K, 32%Can, 32%US broad market, 5% US small-value, 30% international
no bonds, no TFSA (and not real possibility to fill TFSA now because every penny go through RRSP, RESP and mortgage)
Mortgage balance 95K, 5 years remaining with actual schedule. Rate = 3.49% for 2.5 years.
HELOC available 125K increasing 20K/year to top at 220K in October 2019. Rate = prime + 0%

On January 5th, after few transactions, situation would be:

My RRSP : 280K, 0%ZCN, 30%VTI, 40%VBR and 30% VXUS
Wife RRSP : 160K , 35% ZCN, 35% VTI and 30% VXUS
RESP : 70K, 35%RBF556, 35% RBF557 and 30% RBF559
Taxable : 100K, 100%Canadian index ETF (VCN, ZCN or XIC)
Total : 610K, 30%Can, 27%US broad market, 18% US small-value, 25% international

It's only 5 transactions, increase my tilt toward US small-value, increase MER by 80$/year (but lower average MER from 0.17% to 0.15%)

Leverage would be 15% on investment and 20% overall (house value is 340K)

No other debt and no plan to get any, for anything. I buy used and pay cash whenever possible except for food and underwear ;-)

Gross income 80K and wife 30K.

2 sons: 11 and 7 now

Max out RRSP and RESP every single year since 1997 and never get worry with markets (2002-2003, 2007-2008)

I find Vanguard's and BMO's distributions statement pretty clear and complete to manage everything else (taxes, cash transfer etc) but now, I think Vanguard is ahead for 2013, they just have eligible dividends and a trivial capital gain that will increase ROC. Don't know if they will continue that way.

My FIRE plan is to be FI in about 5-10 years and when sons gets older, we could buy some fixer-upper and then rent or resale, who know ?

That's why I would probably stick to 100k$ + capitalized interests. From my assumptions, it should be pretty close of investment value on the long run (over 10-15 years). The capital gain will also be merely taxed if I sell with lower incomes.

I read some of your posts from time to time and will appreciate further comments. Thanks!

 
 

[RichMoose]

I already went through MDJ threads, so everything is set to proceed on January 5th. I just wait for 2015 to skip the hassle of tax filling for spring of 2016. In fact, I will not set a complete (real) SM. I just want to buy a 100k$ chunk and then, capitalize the interests and transfer the dividends in my checking account. The LOC is ready (never used and no plan to use it unless to invest or in case of real big emergency). The separate checking account is open and ready, I drawn my "Flow Chart" etc.

I also read all CCP articles concerning Canadian ETF and tax tips. From what I understand, when you decide to work with ETF in taxable account, and especially when it's with borrowed money, there is some details to know. ROC will decrease ACB; capital gain/share will increase ACB etc. It's still manageable since you know where to get information, how to fill tax papers, decrease the loan if needed.

FYI, I held some individual stock in the past but I prefer to stick with broad index ETF and that's why I just try to pick the best for my situation. I will give you more details I it help.

Perfect, its great to have a clean flow chart so you can easily track your cash should CRA come calling.

I can see another somewhat big issue with using an index ETF you suggest, your dividends are too low. Part of the rule of investment loans to remain tax deductible is the income (interest or dividends, not capital gains) generated from the investment should be higher than the expense of holding the loan. I interpret this to mean if your loan interest is 3%, your dividends should be at least 3%. Those ETF's only generate about 2 - 2.5%. This could be an issue if CRA ever audits you. I'm not an accountant, but maybe CPA CB on the Canada tax questions thread under "Ask A Mustachian" could answer this for you. If this is the case, you may be stuck using XDV (all common stock dividend income) or something like CDZ (includes REITs). If your choice is between these, I would definitely go with XDV and eliminate the hassle of ROC calculations affecting tax-deductibility. I personally believe the real big pain about ROC is that your distributions are monthly or quarterly so you have to go back and back adjustments after each payment as it slowly whittles down the loan's deductibility. Not my idea of a fun time. :)

For the rest, your finances look great and you are doing the right thing by rebalancing your other accounts to maintain your overall AA. Make sure you claim the HELOC interest expense under your name to maximize the tax benefit. I hope by the time I reach your life stage my finances are as well-managed as yours! It's a real shame more Canadians don't do this right.

[Le Barbu]

I can see another somewhat big issue with using an index ETF you suggest; your dividends are too low. Part of the rule of investment loans to remain tax deductible is the income (interest or dividends, not capital gains) generated from the investment should be higher than the expense of holding the loan. I interpret this to mean if your loan interest is 3%, your dividends should be at least 3%. Those ETF's only generate about 2 - 2.5%. This could be an issue if CRA ever audits you.
[/quote]

The interest at 3% - my tax rate 0.38% = 1.9% (btw, new announcement of PC 2 weeks ago says we can split spousal's incomes for tax purpose so, same result here whoever make the claim)

ZCN dividend yield is 0.51$/19.88$ unit = 2.55% * dividends tax rate = 2.3%

I'm 0.4% profit in this case. It’s damned close but it's enough. In future, if value (capital) rise and dividends stay the same around 2,5%, it will probably offset interest rises.

MDJ, on April 3, 2007 says:  "Although CRA only expects income from your investment portfolio, in 2003, the finance department declared that in order for investment loans to remain deductible, the interest/dividends must produce a profit. That is, the dividends must EXCEED the interest that you are paying on the loan. I know, the finance department and the CRA are on different pages. According to Tim Cestnick, the CRA will generally ignore the finance department rules and accept the tax deduction as long as it produces income, but check with your tax professional for the latest rules."

Look like a grey zone here. Let say interest rates rise to 5% in the near future, I'm not sure many investments will still come ahead. CRA should see a "reasonable expectation" of profit on investment but there is no warranty.

I will give a try in the "Ask a Mustachian" section like you recommend

[/quote]
If your choice is between these, I would definitely go with XDV and eliminate the hassle of ROC calculations affecting tax-deductibility.[/quote]

ROC does not mean you got monthly distributions. ZRE gives monthly distributions an include ROC but ZCN gives quarterly distributions, sometime with ROC, sometime without ROC (and sometime capital gain!).

I can't believe I would buy an ETF with 0.5%MER. If I'm in a dead-end with ZCN or VCN, I think I will just buy 10K of 10 different Co listed on XDV and let roll.

[/quote]
I hope by the time I reach your life stage my finances are as well-managed as yours! It's a real shame more Canadians don't do this right.
[/quote]

I hope your finances will look better than mine at this point!

My biggest mistakes? Bought a big house in 2004 but sold it in 2007. Get a Forester 2010 in 2011, hopefully I bought it rebuilt for 50% tag price and paid in cash. Invest in RBC mutual funds until 2012 (1.8% average MER !!!!!) now this have been shaved to 0.17% That was my journey before MMM, now I cannot accept such big ones.