The Tax-Efficient Canadian Monthly Income ETF Portfolio

I'll be honest—I'm primarily a total return investor, focusing on overall growth rather than just income. However, I know many of you are keen on generating income from your investments.

In Canada, becoming an income investor can be straightforward. You can fill your Tax-Free Savings Account (TFSA) with high-yield assets and enjoy tax-free withdrawals on everything from capital gains and dividends to income from bonds and REITs.

But what if you've fully utilized your TFSA contribution room? Just for context, if you turned 18 before 2009 and have never contributed, your maximum lifetime TFSA contribution limit would be $102,000 as of 2025. Once you've hit this limit, your options become more restricted.

In a non-registered (aka taxable) account, tax efficiency becomes crucial. The more tax-efficient your investments, the more of your yield you get to keep.

So, I'm here to guide you through assembling a Canadian income portfolio that uses just two ETFs, letting you hold on to more of your hard-earned money. Let’s get started!

Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY)

First up on my list for a tax-efficient, income-oriented Canadian ETF portfolio is the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY).

This ETF tracks the FTSE Canada High Dividend Yield Index, which includes 56 Canadian stocks predominantly in the financials and energy sectors—think big banks, pipeline and upstream companies, and life insurance companies. It boasts a reasonable expense ratio of 0.22%.

As of October 21, VDY offers a yield of 4.3%, paid on a monthly basis, typically going ex-dividend on the last Friday of each month. But the real great news about VDY’s yield is its tax efficiency.

For example, in 2023, VDY distributed a total annual amount of $2.116449 per share. The majority of this distribution, $1.977849, was classified as eligible dividends, which are taxed favorably due to the dividend tax credit, making them more attractive from a tax perspective.

The remainder of the distribution consisted of capital gains amounting to $0.138600, which are also taxed efficiently in Canada—only 50% of capital gains are taxable up to $250,000 are taxable.

It's also worth noting that VDY's distributions have not historically included any foreign income (which could lead to foreign withholding taxes) or other types of income, as it excludes REITs unlike some other dividend-focused ETFs.

On the rare occasion, such as in down years like 2022, you might see a minimal return of capital, which is employed to smooth out the monthly payments and merely reduces your adjusted cost basis (ACB) without immediate tax implications.

VDY has also been a strong performer over time. From its inception on November 8, 2012, to October 18, 2024, with dividends not reinvested, shares would have compounded at an annualized rate of 6.11%—that's quite impressive.

Even better, if you didn't withdraw those dividends for income and instead reinvested them, your return would jump to 10.39%, surpassing the performance of the S&P/TSX 60 index.

BMO Laddered Preferred Share Index ETF (ZPR)

In our quest for a tax-efficient income portfolio, it's vital to diversify beyond just stocks to include other income-generating assets that are less correlated with the stock market.

In a TFSA, this might typically involve adding bond ETFs, which is straightforward. However, in a non-registered account, the tax treatment of bond income can be burdensome, making this less attractive.

A compelling alternative in this scenario is preferred stock, which can be efficiently accessed through an ETF like the BMO Laddered Preferred Share Index ETF (ZPR).

Preferred shares are a hybrid between stocks and bonds, offering features of both. Like bonds, they often provide fixed dividend payments and are generally less volatile than common stock. Yet, they also resemble stock in that they represent ownership in a company, albeit without the same voting rights.

Now, preferred shares in Canada can sometimes be complex and less liquid compared to common stocks, which is why opting for an ETF over individual issues can be more practical and less risky.

ZPR tracks the Solactive Laddered Canadian Preferred Share Index. This index employs a laddered strategy based on 5-year increments, with each annual "bucket" being equal-weighted, while the constituent securities within each bucket are market capitalization weighted.

This laddering strategy mitigates interest rate risks, as the staggered maturity structure spreads out the impact of rate changes over time, helping to stabilize returns.

ZPR's expense ratio is reasonably low for a preferred share ETF at 0.5%, and it boasts a yield of 5.12% with monthly distributions. The issuers are typical of the Canadian sector, with large allocations to the energy and financial sectors.

The tax efficiency of the distributions is also notable: in 2023, ZPR paid an annual distribution of $0.54 per share, of which $0.496270 was from eligible dividends, benefiting from favorable tax treatment, and a small portion, $0.043730, was a return of capital, which reduces your adjusted cost base.

How to use this portfolio

To effectively utilize this portfolio, simply hold both of these ETFs—VDY and ZPR—in a non-registered account in the proportions that suit your investment strategy. Personally, I prefer a mix of 75% VDY and 25% ZPR, but YMMV.

You can withdraw the monthly distributions as they come in, but it's important to keep an eye on your ACB, especially if any of the distributions include a return of capital. This is crucial for accurately reporting your capital gains or losses to the CRA at the end of the year.

However, a word of caution: this portfolio is entirely invested in the Canadian market. While this can offer substantial tax efficiency and solid returns, ideally, your investment strategy should include a more diverse geographical spread.

U.S. and international investments are best held in your registered accounts, like a TFSA or RRSP, to provide a balance and hedge against the Canadian market's specific risks and to ensure broader exposure to global growth opportunities.