The Tax-Free Financial savings Account (TFSA) sounds easy. Capital positive factors are tax-free. Dividends are tax-free. Curiosity is tax-free. Withdrawals are tax-free. That’s principally true.
However there’s one vital asterisk that an increasing number of Canadian buyers are slowly discovering. If you happen to maintain U.S. shares, U.S.-listed exchange-traded funds (ETFs), and even Canadian ETFs that personal U.S. shares, there’s a hidden price inside your TFSA.
Particularly, a 15% international withholding tax charged by the U.S. Inner Income Service (IRS). Right here’s what meaning and what you are able to do about it.
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The 15% international withholding tax defined
Underneath the Canada-U.S. tax treaty, dividends paid by U.S. corporations to Canadian buyers are topic to a 15% withholding tax.
In a taxable account, you possibly can often declare a international tax credit score. However inside a TFSA, you can’t get better it. The cash is solely withheld earlier than it ever reaches you.
For instance, in case you personal a U.S. ETF yielding 1%, you don’t really obtain 1%. After the 15% withholding tax, your efficient yield turns into 0.85%. You may suppose, “That’s solely a 0.15% distinction. Not an enormous deal.”
In a single yr, possibly not. However over many years, reinvested dividends are a serious driver of whole return. Even small reductions compound into significant variations over time.
This is applicable to U.S. shares listed on U.S. exchanges, U.S.-listed ETFs, and Canadian-listed ETFs that maintain U.S. shares. Within the case of Canadian ETFs holding U.S. shares, the withholding tax occurs earlier than the dividend even lands contained in the ETF.
How will you scale back or keep away from it?
There are a number of methods to handle this, every with trade-offs. If you happen to insist on holding U.S. publicity inside your TFSA, one strategy to reduce the injury is to give attention to corporations or ETFs that pay little or no in dividends.
Many growth-oriented sectors, resembling know-how, communications, and shopper discretionary, have comparatively low yields. For instance, ETFs monitoring the NASDAQ-100 — an index of 100 large-cap U.S. development shares — traditionally pay modest dividends.
One Canadian-listed instance is Invesco NASDAQ-100 Index ETF (TSX: QQC), which fees a 0.20% expense ratio.
One other method is to personal U.S. corporations that don’t pay dividends in any respect. Some companies favor to reinvest income internally or repurchase shares somewhat than distribute money. Which means no dividend, and subsequently no withholding tax.
A traditional instance is Berkshire Hathaway (NYSE:BRK.B), which has traditionally not paid dividends.
As a substitute, it compounds capital internally and infrequently repurchases shares. It additionally sits on a large money pile of roughly $380 billion and owns a diversified assortment of public shares and wholly owned working companies.
In case your purpose is particularly to gather U.S. dividends with out dropping 15%, the extra tax-efficient place to carry them is your Registered Retirement Financial savings Plan (RRSP).
The IRS acknowledges the RRSP beneath the Canada-U.S. tax treaty. Which means direct U.S. shares and U.S.-listed ETFs held inside an RRSP are exempt from the 15% withholding tax.
Vital caveat: this exemption applies to direct U.S. securities. Canadian-listed ETFs that maintain U.S. shares don’t obtain this profit, even in an RRSP.