The TFSA’s Hidden Fine Print When It Comes to U.S. Investments

The Tax-Free Savings Account’s tax-free status comes with one big asterisk that many investors miss. If you own U.S. stocks or U.S.-listed exchange-traded funds (ETFs) inside a TFSA, 15% of the dividend is lost to foreign withholding tax.

This tax is unavoidable. It is withheld at source by the IRS, and there is no way to recover it inside a TFSA. The only registered account that avoids this drag is a Registered Retirement Savings Plan (RRSP).

Given how powerful the TFSA is, this is often a non-issue for newer investors. If your U.S. exposure is modest, or you focus on companies that pay little or no dividends, the impact is small.

Still, as your portfolio grows, this is something worth optimizing earlier rather than later. Here is what you need to know if you’re considering investing in U.S. stocks or ETFs in a TFSA.

What happens if you own a U.S. ETF or stock

Take the Vanguard S&P 500 ETF (NYSEMKT:VOO), as an example. It is one of the most popular U.S. equity ETFs, with a very low 0.03% expense ratio.

As a Canadian investor, buying VOO also means converting your dollars into U.S. currency. With modern brokerages, that step is cheaper and easier than it used to be, but it does not solve the core issue.

Inside a TFSA, the roughly 1.1% 30-day SEC yield paid by VOO is automatically reduced by 15% due to foreign withholding tax. You never see that money, and you cannot claim it back.

When those smaller dividends are reinvested over time, the lost income creates a modest but real drag on long-term growth. Because of this, converting currency to buy VOO in a TFSA rarely makes sense when a Canadian-listed alternative exists.

The Canadian option

A simpler approach is the Vanguard S&P 500 Index ETF (TSX: VFV). It provides the same S&P 500 exposure as VOO but trades in Canadian dollars, so there is no need to convert currency.

The expense ratio is higher at 0.09%, but in dollar terms, the difference is minimal even on large balances. The yield is lower at about 0.92%, reflecting both the higher fee and the same underlying foreign withholding tax that applies to U.S. dividends.

Economically, the two ETFs are very similar. From a practical standpoint, VFV is simply more convenient for Canadian investors using a TFSA, or if your brokerage doesn’t offer low-cost currency conversion.

The post The TFSA’s Hidden Fine Print When It Comes to U.S. Investments appeared first on The Motley Fool Canada.

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More reading

• The Best $21,000 TFSA Approach for Canadian Investors
• 3 Reasons VFV Is a Must-Buy for Long-Term Investors
• Got $500? These 2 TSX Value Plays Are Too Affordable to Ignore
• Want a $1 Million Retirement? 2 Easy ETFs to Buy and Hold Forever

Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.