A Tax-Free Savings Account (TFSA) does what the name implies—it shields your investment gains and income from taxes. But there’s one exception: U.S. stocks and exchange-traded funds (ETFs) held in a TFSA still get hit with a 15% withholding tax on dividends.
You can sidestep this issue by sticking to growth companies that don’t pay dividends, but that’s not always ideal. For dividend-heavy ETFs, the tax drag adds up. The better solution is to use a Registered Retirement Savings Plan (RRSP).
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What is an RRSP?
The RRSP is Canada’s main retirement savings account. Each year, you can contribute up to 18% of your earned income, capped at a set maximum. Contributions reduce your taxable income, giving you an upfront tax break, but withdrawals in retirement are taxed as income.
Since most people earn less in retirement than during their working years, the taxes you eventually pay are usually lower than what you saved when contributing, making RRSPs especially attractive for high earners looking to cut today’s tax bill.
Crucially, though, RRSPs get special treatment with U.S. securities. Thanks to the Canada-U.S. tax treaty, dividends from American stocks and ETFs are not subject to the 15% withholding tax if held directly in an RRSP. That makes the RRSP the perfect home for U.S. dividend-paying stocks and ETFs.
The best ETF for an RRSP
For most investors, the best U.S. ETF to hold in an RRSP is Vanguard S&P 500 ETF (NYSEMKT:VOO), which is currently the most popular ETF in the world based on assets under management.
It gives you exposure to 500 of America’s largest publicly traded companies across all 11 stock market sectors, weighted by market capitalization. That means the biggest firms make up a larger slice of your investment, while weaker companies gradually shrink in importance.
The ETF is also dirt cheap, charging just a 0.03% management expense ratio, or $3 annually on every $10,000 invested. With no withholding tax drag inside an RRSP, every dollar of dividends and growth is yours to keep until you withdraw in retirement.
The Foolish takeaway
If you’re looking to make the most of your RRSP, prioritize U.S. ETFs here instead of in your TFSA. VOO gives you broad exposure to the S&P 500, costs almost nothing to own, and avoids the dividend withholding tax altogether. For long-term retirement saving, it’s one of the most efficient tools available to Canadians.
