Here, at Investor Clinic, we take our mission to inform, educate and inflict maximum mental pain seriously. That's why barely a week goes by without a detailed discussion of an arcane investing topic such as return of capital, phantom distributions or U.S. withholding taxes.
But what if you're not into understanding a lot of esoteric investing terminology? What if all you want to do is make your investing plan as simple and straightforward as possible, while minimizing the need for extra record-keeping and paperwork at tax time?
Well, good news: I've developed a five-step program just for you. Following this program won't necessarily generate the highest or most tax-efficient returns, but it will reduce your workload and stress level and might even save you a few bucks in accounting fees.
What's that? You like filling out tax forms and digging up historical ETF distributions? Then, by all means, carry on. But if you'd rather use your time for other things, then consider the tips that follow.
Keep your "messy" stuff in a registered account
Some securities require a lot of busy work. Many real estate investment trusts and exchange-traded funds, for example, distribute return of capital (ROC). In a non-registered account, you have to deduct these pesky ROC payments from your adjusted cost base (ACB) to calculate your capital gain when you sell. Not your idea of fun? Solution: Hold ROC-paying investments in a tax-free savings account (TFSA) or registered retirement savings plan (RRSP) instead. Because there are no capital gains taxes in registered accounts, you can ignore ROC altogether. The same goes for ETFs with reinvested – or "phantom" – distributions. In a non-registered account, you have to add these distributions to your ACB, but if you keep these ETFs in a registered account, you'll never have to look up a phantom distribution again.
Keep your U.S. dividend stocks in a retirement account
If you hold U.S. dividend stocks in a non-registered account, three things will happen: 1) Because U.S. stocks don't qualify for the dividend tax credit, you will pay Canadian tax on the full amount of the dividend; 2) The U.S. government will keep 15 per cent of the dividend as withholding tax; 3) If you want to recoup the U.S. tax, you'll have to file with the Canada Revenue Agency to receive a foreign tax credit. Want to avoid all that? Hold your U.S. dividend stocks in an RRSP, RRIF, LIRA or other retirement account. You won't pay any Canadian tax on the dividend and – thanks to the U.S.-Canada tax treaty – you won't face any U.S. withholding tax, either. But be careful: The withholding tax exemption applies to retirement accounts only, not to TFSAs or registered education savings plans.
Keep trading to a minimum
Warren Buffett once said that his "favourite holding period is forever." There will be times when you have to sell – when you need the cash or the company has taken a permanent turn for the worse, for example – but ideally your goal should be to buy great companies and hold them through thick and thin, while collecting – and reinvesting – dividends along the way. If you trade a lot, not only will you pay more in commissions, but you'll constantly have to calculate capital gains and losses (and possibly pay more tax overall). You'll also develop acid indigestion because trading is stressful and doesn't always pan out the way you had hoped.
Don't stick your neck out
Recently, a reader was asking about a REIT with an 11-per-cent distribution. He wanted to know whether the juicy payout is safe. Well, I haven't studied the REIT in detail, but if I owned anything with an 11-per-cent yield, I'd have a bad case of sweaty palms. There's just no way an investment can pay such an eye-popping yield without elevated risk to the distribution, the unit price, or both. In my experience, the trick to owning income stocks is to control your greed: If you focus on companies that yield, say, from 3 per cent to 6 per cent (that's just a rough guideline), you'll greatly reduce the chances of a blowup. To further reduce your risk, look for: 1) a history of dividend increases; 2) a payout ratio that's comfortably under 100 per cent and; 3) growing earnings and cash flow. Some companies that meet these tests include utility operator Fortis Inc. (FTS), telecom service provider Telus Corp. (T) and diversified real estate owner Canadian REIT (REF.UN). I'm not saying a high yield is always unsustainable, but you had better know the company inside out when you're getting into high single-digit or double-digit yields.
Invest in diversified funds
If owning individual stocks makes you nervous, there's a simple solution: Buy low-cost index ETFs or mutual funds instead. Downside: You'll pay more in fees and won't have the same control over your weighting in each company. Upside: You'll improve your diversification and won't have to monitor the performance of each company because you can't buy and sell the fund's individual holdings, anyway. You'll also likely worry less because if one or two stocks in the fund get into trouble, the impact on your portfolio will be minimal. By following this and the other steps outlined here, you'll be on your way to a simpler, less stressful, more rewarding investing experience.
John Heinzl