What the Fine Print Really Says About U.S. Stocks in Your TFSA

The Tax-Free Savings Account (TFSA) is one of the best investment accounts available to Canadians. Within that account, dividends can compound tax-free. That being said, there are some wrinkles about that rule that investors should know when it comes to holding U.S. stocks in your TFSA.

The truth sits somewhere in the middle.

U.S. stocks can be purchased and held in a TFSA. Where the different rules come into play is when those U.S. stocks include dividend-payers.

Let’s clarify something

It can sound confusing, but Canadian investors can hold U.S. stocks in a TFSA. If a U.S. stock rises in value inside the account, the capital gains are sheltered from Canadian tax. Withdrawals from the TFSA also remain tax-free.

That’s still a powerful advantage. It means an investor who holds a high-quality U.S. business for many years can still benefit from long-term compounding inside a tax-free account.

A great example is Nvidia (NASDAQ:NVDA), where long-term holders have seen massive capital gains that remain tax-free inside the TFSA.

The real wrinkle shows up when those U.S. stocks pay dividends. That detail can affect income-focused investors more than growth-focused investors.

The fine print is the withholding tax

The key detail is that U.S. dividends don’t get the same tax treatment inside a TFSA. This happens because the TFSA isn’t recognized under the U.S.-Canada tax treaty as a retirement account. Instead, the IRS treats TFSA accounts and their U.S.-earned dividends as coming from a taxable account.

When a U.S. company pays a dividend to a Canadian investor inside a TFSA, part of that dividend is generally withheld before it reaches the account.

Consider Procter & Gamble (NYSE:PG), which is one of the largest consumer brands on the planet. It offers products such as Pampers, Swiffer, and Crest sold worldwide.

Given that defensive moat and 3% yield, that would make Procter & Gamble a great addition to a TFSA, right?

Inside a TFSA, a Procter & Gamble investment won’t receive the full tax-free treatment. A withholding tax reduces the cash paid out on that dividend.

This doesn’t make the stock a bad TFSA holding. In fact, Procter & Gamble is a superb long-term option. All it means is that investors should know what they are giving up in dividend income.

Why Procter & Gamble and Nvidia still belong in a TFSA

Another common mistake some investors make is dismissing U.S. stocks entirely out of concern for that withholding tax. That takes it too far.

The withholding tax is only one part of the decision. Holding U.S. stocks in your TFSA can still make sense for investments like Procter & Gamble for the diversification and total return.

The same could be said of Nvidia. Withholding tax on its small dividend is a rounding error compared to the growth potential.

The key is expectations. Holding U.S. stocks in your TFSA is not the cleanest solution from a tax standpoint, but they can still be strong long-term holdings for investors who want U.S. blue-chip exposure.

There is a cleaner Canadian alternative

For investors who want that income-earning potential without the same U.S. dividend tax concern, Fortis (TSX:FTS) is the cleaner TFSA fit.

Fortis is one of the largest utility stocks in North America, with regulated electricity and gas operations across Canada, the U.S., and the Caribbean.

The advantage for investors in a TFSA is simplicity. A Canadian dividend stock like Fortis doesn’t create the same U.S. withholding tax issue for Canadian investors.

Because the dividends originate from a Canadian company, the full payout lands in the TFSA with no foreign tax leakage. That means the income paid into the TFSA is straightforward and more efficient from a cash-flow perspective.

As of the time of writing, Fortis offers a quarterly dividend that pays a yield of 3.2%. The company has also provided investors with annual upticks to that dividend for over 50 consecutive years.

The bottom line for TFSA investors

Knowing what the fine print on holding U.S. stocks in your TFSA says can save on taxes over the long term. And it doesn’t mean avoiding U.S. stocks entirely is right.

The best approach is not to avoid U.S. stocks altogether, but to understand where they fit best. Procter & Gamble may still work for diversification and quality, while Fortis offers a cleaner Canadian income option.

The post What the Fine Print Really Says About U.S. Stocks in Your TFSA appeared first on The Motley Fool Canada.

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Fool contributor Demetris Afxentiou has positions in Fortis and Nvidia. The Motley Fool recommends Fortis and Nvidia. The Motley Fool has a disclosure policy.