Small-Print TFSA Rules Affecting U.S. Stocks

Do you want to hold U.S. stocks in your tax-free savings account (TFSA)?

If so, your thinking is probably sound. The U.S. market is one of the best long-term performers on the entire planet. However, when holding U.S. stocks in a TFSA specifically, there are some fine-print rules you might want to keep in mind. In some cases, violating these rules can result in taxation – even if you’re holding stocks in a “tax-free” account. The following are three of the most important to keep in mind.

The foreign dividend withholding tax

If you’re holding foreign dividend-paying stocks in your TFSA, you most likely will have to pay taxes to foreign tax authorities. This is because such tax authorities charge dividend withholding taxes – taxes on dividends paid to foreign shareholders. These taxes are basically there to minimize the amount of money flowing out of the countries in question. Canada charges them to foreign shareholders as well. If you hold U.S. stocks – as most Canadians do – you’ll pay 15% on any dividends earned, and the TFSA won’t spare you those taxes. Interestingly, the RRSP does spare you the 15% U.S. dividend withholding tax, but that’s a topic for another day.

The ETF trap

Another way to end up getting taxed in a TFSA is to hold a Canadian-domiciled ETF of U.S. stocks. Even though such a fund is Canadian, it still incurs the dividend withholding tax– in this case, at the fund level. So, holding such an ETF in a TFSA won’t spare you the withholding tax. It’s taken out before any dividends even hit your account!

Over-the-counter (OTC) stocks

Over-the-counter (OTC) U.S. stocks are another source of potential problems for TFSA holders. Unless the same stocks also trade on designated exchanges, then they aren’t considered approved TFSA investments. If you hold a U.S. stock that is only traded OTC, you may have to pay taxes on it.

The way to avoid this small print “gotcha” rule is simple:

Invest primarily in stable, reputable, blue chip companies. Such companies tend to trade on legitimate exchanges, thereby avoiding the problems with OTC markets. When these companies trade in Canada and pay dividends, that’s even better, because Canadian dividends are not taxed when you hold them

You can even buy a whole portfolio, through an exchange traded fund (ETF) like the iShares S&P/TSX Capped Composite Index Fund (TSX:XIC).

XIC is a diversified portfolio of TSX stocks that itself trades on the TSX stock exchange. It tracks the S&P/TSX Capped Composite Index, a list of the 240 biggest publicly traded companies in Canada. It actually holds about 220 of those 240 stocks, so it represents its index well, if not perfectly.

Not all ETFs are necessarily worth investing in. Just like individual stocks, some are good, others are bad. XIC is not just any ETF, though– it’s an index ETF, meaning it tracks an entire chunk of a total market, in this case the Canadian one. There is ample academic research showing that index funds tend to outperform stock picking (including active funds) over time.

A big part of how index ETFs achieve their strong long-term performance is through low fees. Many of them charge as little as 0.01% per year! In XIC’s case, the management fee is 0.05% and total costs are 0.06% per year. Not the absolute lowest in the industry, but certainly reasonable.

With a portfolio of Canadian funds like XIC, your TFSA will be well-equipped to weather whatever storms befall the market. And you won’t have to worry about any arcane TFSA tax rules while you’re holding them.

The post Small-Print TFSA Rules Affecting U.S. Stocks appeared first on The Motley Fool Canada.

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More reading

• 2 Canadian ETFs to Buy and Hold in a TFSA Forever
• How Much a Typical 45-Year-Old Has in TFSA and RRSP Accounts
• 3 Canadian ETFs Worth Tucking Into a TFSA and Holding for the Long Haul

Fool contributor Andrew Button has no positions in the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.