When are tax-deferred and tax-free accounts actually taxable?


Q. I saw your blog online; thank you so much for the wonderful job that you are doing—it was very informative! That motivated me to start investing too, but now I have a couple of questions. I understand that there is tax on US dividends in TFSA, do we pay tax as well when we sell:

  • U.S. stocks in TFSA
  • U.S. stocks in RRSP
  • Canadian stocks in RRSP

–Tawheeda

A. It’s great to hear we motivated you to start investing, Tawheeda. Stocks are a great way to build wealth for the long term, despite the short-run volatility. Tax plays a role in your portfolio construction and returns, so let me explain the implications. 

Tax-free savings accounts (TFSAs) are mostly tax-free. When you buy and sell an investment for a profit, that is tax-free inside a TFSA, regardless of the type of investment. 

One exception could be if you are day trading in your TFSA. If you are engaging in frequent trading activity, there is a risk your profits could become taxable as business income. For most long-term, buy-and-hold investors, this is not an issue.

U.S. stocks held in a TFSA are subject to 15% withholding tax on U.S. dividend income. The same would apply to other foreign stocks held in a TFSA, with rates starting at 15%, depending on the country. Only Canadian stocks are not subject to withholding tax on their dividends inside a TFSA. 

Does this mean you should only hold Canadian stocks in your TFSA? Not necessarily. If your TFSA is your primary investment account, or a big part of your overall investments, you may need to hold non-Canadian stocks to have diversification. If it is a small part of your overall portfolio, you may be able to have a bias towards Canadian stocks in your TFSA, but that may or may not be the best investment strategy depending on the value and type of your other investment accounts. Canada is a small part of the global stock market and has little exposure to sectors like technology and health care, so foreign stocks help diversify and can increase risk adjusted returns. 

Can you avoid foreign withholding tax by holding Canadian mutual funds or exchange traded funds (ETFs) in your TFSA, Tawheeda? Unfortunately, no. They, too, are subject to withholding tax on foreign dividend income, so even though you will not see withholding tax on your TFSA statement, the mutual fund or ETF itself would have withholding tax before receiving dividends from foreign stocks. TFSA withdrawals are always tax-free. However, if you over-contribute to your TFSA, in excess of your TFSA limit, you may be subject to a penalty tax and interest. 

When you buy and sell for a profit in your Registered Retirement Savings Plan (RRSP), the proceeds are not generally subject to tax. The same business income treatment could apply to day trading in your RRSP, like your TFSA, but this would require frequent trading in your account. 

U.S. dividends may or may not have withholding tax in your RRSP, Tawheeda. If you own U.S. stocks directly in your RRSP, there will be no withholding tax. If you own U.S. stocks through a U.S. ETF, you will not have withholding tax, either. However, if you own U.S. stocks indirectly through a mutual fund or an ETF listed on a Canadian stock exchange, that mutual fund or ETF will be subject to U.S. withholding tax on any dividends before it receives them, even though you will not notice any withholding tax on the dividends or distributions you personally receive from the fund. You see, a Canadian mutual fund or ETF is itself considered a non-resident of the U.S., subject to 15% withholding tax. The account the fund is held in does not matter. The withholding tax will still apply.  

Foreign stocks in a RRSP will generally have at least a 15% withholding tax rate as well, depending on the country of origin and the tax treaty that country has with Canada. Foreign withholding tax will reduce returns on foreign stocks owned directly as well as indirectly through a mutual fund or ETF.

RRSP withdrawals are fully taxable, so eventually, all contributions, income and capital gains become taxable income. Two exceptions are withdrawals under the Home Buyer’s Plan for a home purchase, or the Lifelong Learning Plan for post-secondary education. 

Buying U.S. stocks in your TFSA or RRSP requires converting Canadian dollars to U.S. dollars, and that has a cost. Foreign exchange transactions can cost an investor 1% to 2% in a brokerage account. Tax withholding savings could be 15% of future dividend income, and assuming a 1.55% dividend—the current dividend yield for the S&P 500—the annual savings on withholding tax would be 0.2325% per year. It could take five to nine years to recoup the foreign exchange cost, assuming a 1% to 2% foreign exchange conversion rate. 

The tax treatment of RRSP and TFSA withdrawals should motivate investors to choose their asset allocation wisely between not only types of stocks, but also stocks and bonds. It may be beneficial to hold more fixed income in an RRSP and more stocks in a TFSA. That way, growth should occur primarily in a tax-free TFSA, instead of a tax-deferred RRSP that will someday be taxable.

Investing is about more than just picking stocks. Risk tolerance, asset allocation, fees and tax all play a role as well. Reducing tax increases returns, and increasing returns increases your ability to become or stay financially independent.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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