CRA: If You Make This TFSA Mistake, the IRS Will Tax You, Too!

If you want to avoid getting taxed on dividends by the IRS, consider buying Canadian ETFs like iShares S&P/TSX 60 Index ETF (TSX:XIU).

| More on:
Man with no money. Businessman holding empty wallet

Image source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn more

Do you want to enjoy the tax benefits that come with owning a TFSA?

If the answer to that question is yes, then you’ll want to pay close attention to the account rules.

Not only can certain mistakes get you taxed by the CRA, but there are other subtle no-nos that can cost you as well.

Overcontributing is a classic TFSA error that get land you with a whopping 1% a month tax. Holding cash is another no-no, as it makes your “tax savings” negligible.

In this article, I’ll explore another little-known TFSA mistake that can cost you big time. This is a subtle mistake that few people know about, but it can cost you huge amounts of money — particularly if you invest in dividend stocks. If you make this mistake, you could find yourself paying up to 15% a month on dividends, even in your “tax-free” account. And with this doozy, it’s not the CRA that’s the problem at all, but the IRS!

Holding investments that produce U.S.-originated income

If you hold U.S. investments that produce dividend income in your TFSA, expect to pay a tax. It doesn’t matter how much you’ve contributed, how long you’ve held your account for, or whether you have more than one TFSA. If your TFSA contains U.S.-based, dividend-dealing stocks, the IRS will take a 15% cut.

Why the IRS gets to tax you

It all comes down to withholding tax. Generally, countries want to prevent capital outflows, and dividends paid by their companies fall under their tax jurisdiction even if the owner is foreign. This gives them the ability to tax foreigners on dividends, even though they’re not under their income tax jurisdiction.

The U.S. is not alone in this. In fact, most countries charge foreign dividend withholding taxes of one form or another. But as a Canadian investor, you likely own more stocks based in the U.S. than anywhere else, so this particular withholding tax is one to watch out for.

What to do instead

Before getting into what you should do about foreign withholding taxes, one thing needs to be mentioned: an extra dividend tax isn’t a reason not to own a stock.

Many stocks are good investments, even with 15% of the dividend shaved off — particularly if any capital gains are tax-free in your TFSA.

However, generally speaking, if you have the contribution room in both, it’s best to keep your U.S.-based dividend stocks in your RRSP. Here, the foreign withholding tax is exempt, so you enjoy tax deferment on both dividends and capital gains.

As for what you should hold in your TFSA, that’s more complicated. Ultimately, it comes down to your own investing style, especially how much risk you’re willing to take on.

However, Canadian ETFs like the iShares S&P/TSX 60 Index ETF (TSX:XIU) can be great candidates.

As a Canadian ETF of Canadian stocks, XIU doesn’t own anything subject to foreign withholding taxes. This means that it takes full advantage of the tax-exempt features of the TFSA. As a relatively high-yield ETF, it pays you sizable dividends that are completely tax-free inside a TFSA. Not only that, but the yield is higher than U.S. ETFs like VOO, so the starting amount of dividend income is preferable to that of IRS-taxed U.S. funds.

XIU and its sister fund XIC have long been favourites of Canadian investors, owing to their strong diversification and relatively high yields. These factors do indeed make them very desirable as investments. When you add in the fact that they’re both totally tax-free inside a TFSA, it becomes a no-brainer.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button owns shares of iSHARES SP TSX 60 INDEX FUND.

More on Dividend Stocks

analyze data
Dividend Stocks

2 Safe Dividend Stocks That Could Help You Fight Inflation

A dependable stream of passive income is one way to help offset rising inflation rates. Here are two top dividend…

Read more »

edit Person using calculator next to charts and graphs
Dividend Stocks

Stay Invested in a Recession: Increase Positions in 2 Value Stocks

The suggestion of market analysts is to increase positions in two value stocks if you want to stay invested amid…

Read more »

Hand arranging wood block stacking as step stair with arrow up.
Dividend Stocks

3 Dividend Stocks to Buy as Inflation Surges in Canada

If you're worried about how surging inflation may impact your portfolio, here are three of the best dividend stocks to…

Read more »

You Should Know This
Dividend Stocks

High Inflation: The Good and the Bad for Canadians

Consider tucking away some of your long-term savings in quality dividend stocks like Brookfield Infrastructure in this correction.

Read more »

Dividend Stocks

TFSA Investors: Turn $1,000 Into $10,000 in 10 Years

10-fold growth within a decade is rare but not unheard of. You can capture this growth either by predicting a…

Read more »

edit Real Estate Investment Trust REIT on double exsposure business background.
Dividend Stocks

1 Oversold REIT Stock to Buy for Safe Dividends

If you're looking for stable dividend income from an oversold stock, this office REIT is a perfect option.

Read more »

edit Real Estate Investment Trust REIT on double exsposure business background.
Dividend Stocks

3 Cheap Canadian REITs to Buy in 2022

Are you looking for passive income? Start treasure digging in cheap Canadian REITs in this market correction!

Read more »

Dividend Stocks

TFSA Passive Income: 3 Undervalued, High-Yield TSX Dividend Stocks to Buy Now

These top TSX dividend stocks with high yields now look attractive to buy for TFSA passive income.

Read more »