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How am I taxed on 100% RRSP-eligible index mutual funds that invest in foreign stock markets, assuming I hold them outside my RRSP?

Your investment return from these funds is taxed at your highest rate. Canada Customs and Revenue Agency considers these earnings to be ordinary income -- the same as interest -- rather than as less heavily taxed capital gains.

Instead of buying the actual stocks in a foreign stock market index, these funds benefit from foreign exposure by using derivatives contracts, such as forwards and futures, on foreign stock indexes.

These derivative-based index funds are fully eligible for registered plans like RRSPs because most of their money is held in Canadian government T-bills. You do not have to worry about Canada Customs and Revenue Agency's rule that limits your RRSP's foreign content to 30% of the original or book value of the investments in your plan because such funds are not considered to be foreign content.

Indexing is a passive management style where the fund manager merely tries to match rather than beat a particular stock market index. An index fund with U.S. exposure might buy derivatives contracts on the Standard and Poor's 500 Index, which represents 500 large American companies. Derivatives give these funds the same exposure to the index as a stock-based index fund, but with a much smaller investment than buying the stocks themselves.

Since the earnings generated by derivative-based index funds are considered to be regular income, you should consider holding these funds inside your RRSP where the returns are sheltered from tax.

If you are holding an index fund outside an RRSP, it may make sense to instead use a stock-based index fund since taxes in that case are based on the lower rates for capital gains and dividends.

An argument for using indexing is that managers of most actively managed mutual funds do not consistently beat the market. Why not just buy an index fund, and save the extra costs of paying an active manager?

Indexing has a downside. In a falling market, your index fund will follow the market down. The manager of an actively managed stock fund might be able to ease the fall by shifting some of the stock holdings into cash-type assets.

If you plan to use an index fund, determine whether it has done a good job of closely tracking its index. Some index funds have a high tracking error.

You should compare the ongoing management cost of different funds, since there can be large differences. These costs are reflected in a fund's management expense ratio (MER).

An investment suitable for one investor might not meet your needs. You should also consider seeking professional investment advice.