The article “FP Answers: What are the problems associated with holding U.S. stocks in a TFSA?” was originally published in Financial Post on July 28, 2023, Last updated Jan 10, 2024. By Julie Cazzin with Andrew Dobson.
You may be able to have your cake and eat it, too
Q: I have recently been reading about holding U.S. stocks in a tax-free savings account (TFSA) and how this could be problematic due to U.S. withholding taxes. I still have contribution room in my registered retirement savings plan (RRSP). Should I move my U.S. blue chip stocks from my TFSA to RRSP? Would this be beneficial tax-wise for me? Many people have offered varying opinions, but most seem to say “it depends.” — Trevor
FP Answers: There are two main schools of thought on holding U.S. stocks. On one hand, there is a consideration for how U.S. stocks are taxed in both registered and non-registered accounts, and how this taxation is different for Canadian stocks. On the other hand, there is the value of holding U.S. stocks as an asset class for diversification. I’ll focus on the taxation piece and then tackle why investors may choose to buy U.S. stocks and in which accounts.
First, holding U.S. dividend-paying stocks in TFSAs will lead to a 15-per-cent withholding tax on that dividend when received (either in cash or on a dividend reinvestment plan). This applies to common or preferred shares held directly or those held within managed products such as exchange-traded funds or mutual funds.
The withholding tax is non-recoverable since you can only get credit for foreign tax paid on taxable investment income on your tax return, and TFSAs are, of course, tax free. As a result, some investors may steer away from U.S. stocks in their TFSA.
RRSPs and non-registered accounts deal with withholding tax differently. For RRSPs, there is a tax treaty between Canada and the U.S. that acknowledges the RRSP as a tax-deferred vehicle and, therefore, income from U.S. stocks will not have a withholding tax.
Non-registered accounts holding U.S. dividend-paying stocks will generally have withholding taxes on U.S. dividends. But investors can claim a foreign tax credit on their Canadian tax return that reduces the Canadian tax otherwise payable.
My suggestion, Trevor, is to consider what the withholding tax would actually be for your investment. Using an example, let’s assume that ABC Widgets is a U.S. publicly-listed manufacturer with common shares trading for US$100. ABC pays a monthly dividend of 37.5 cents U.S. per share, or US$1.50 quarterly. With a share price of US$100, this represents an annual yield of 1.5 per cent. If this stock was held in a TFSA, 15 per cent, or 22.5 cents U.S. per share, of that dividend would be taxed without recovery.
As a percentage of the total yield, a withholding tax of 15 per cent may or may not seem significant. However, it may not have much of an impact on your overall returns. The S&P 500 currently has a dividend yield of 1.5 per cent, similar to our ABC Widget example. FP Canada, the governing body for certified financial planners practising in Canada, suggests using a rate-of-return assumption for U.S. equities of 6.6 per cent annually.
If we use the expected S&P 500 returns from FP Canada, the impact of a 15-per-cent withholding tax on a dividend yielding 1.5 per cent on a portfolio earning 6.6 per cent would be a loss of 3.41 per cent on the entire return. This essentially means that on a total return of US$6.60 from a portfolio worth US$100, you would lose 22.5 cents U.S. in withholding tax. Losing 3.41 per cent of your return seems like a small price to pay for diversification and potentially higher returns.
The bigger question of moving U.S. stocks to your RRSP has less to do with the withholding tax, and more to do with your overall tax situation. Instead of whether to hold U.S. stocks or not, Trevor, you may want to consider whether you should invest in a TFSA or RRSP and why?
If you have money in your TFSA and you have RRSP room, you are forgoing tax deductions and tax refunds. If your income is moderate or high and you expect to be in a lower tax bracket in retirement, you will probably come out ahead by contributing to your RRSP. This assumes the savings you have are strictly for retirement.
You can take a withdrawal from your TFSA, tax free, and contribute it to your RRSP, yielding a tax refund in the range of 20 per cent to 50 per cent depending on your income and your province or territory of residence. The TFSA withdrawal gets added back to your TFSA contribution room on the following Jan. 1. So, you may be able to have your cake and eat it, too, by holding U.S. stocks in your RRSP, avoiding the withholding tax and getting a tax refund.
The concept of managing your assets based on how they are taxed is referred to as tax-location strategy. There can be benefits to managing your investments based on tax efficiency, but it can also lead to a worse investment strategy.
If you avoid U.S. stocks, you are ignoring sectors you cannot invest in here in Canada, such as technology and health care, let alone multinational companies that earn more global revenues than those focusing on the Canadian market.
In your case, Trevor, I would start with whether you should be contributing to your RRSP from your TFSA savings, and then consider where to own your U.S. stocks. Even if you do end up buying U.S. stocks in your TFSA, the actual cost relative to your potential return could be very little. As I’ve always said, don’t let the tax tail wag the dog.
Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, On. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.
