You would think that a Tax-Free Savings Account (TFSA), given its name, means everything you earn inside it is yours to keep. For the most part, that is true.
Capital gains are tax-free. Canadian dividends are tax-free. Interest income is tax-free. Withdrawals are also completely tax-free, which is one reason the TFSA is arguably one of the best investment accounts available to Canadians.
The one notable exception is not actually the fault of the Canada Revenue Agency (CRA). Instead, you can thank our counterparts down south, the Internal Revenue Service (IRS).
Under current tax treaty rules, the United States does not recognize the TFSA as a retirement account. As a result, when Canadians hold U.S. stocks or U.S.-listed exchange-traded funds (ETFs) inside a TFSA, the U.S. government withholds 15% of any dividends before they ever reach your account.
There is no way around this withholding tax inside a TFSA. That sounds alarming at first, but in practice it is usually less important than many investors think. Still, there are a few situations where it can matter, and it is worth understanding the difference.
Image source: Getty Images
Understanding the withholding tax
The easiest way to think about the withholding tax is that it reduces your dividend income. Suppose you own a U.S. stock that pays a 1% dividend yield. Because of the 15% withholding tax, your effective yield becomes:
At first glance, that may not seem like much. However, over long periods of time, those lost dividends can slightly reduce compounding because reinvested dividends contribute to long-term portfolio growth.
The one major exception is the Registered Retirement Savings Plan (RRSP). Unlike a TFSA, the RRSP is recognized under the Canada-U.S. tax treaty. That means U.S. stocks and U.S.-listed ETFs held directly inside an RRSP generally avoid the 15% withholding tax entirely.
Does it really matter?
In many cases, not as much as people think. If you primarily own U.S. growth stocks, particularly those in the technology sector, the withholding tax often has very little impact because dividend yields are already low or nonexistent. Many investors have probably been paying withholding tax for years without even noticing because the underlying dividend yield was so small.
That is also one reason I have always had a soft spot for Berkshire Hathaway (NYSE:BRK.B). The company pays no dividend and instead compounds shareholder value by retaining earnings and reinvesting them internally.
The situation changes somewhat if you specifically target high-yield U.S. dividend stocks or income-focused ETFs. In those cases, the withholding tax becomes much more noticeable because it is being applied to a larger income stream.
Even then, though, I would not lose sleep over it. Yes, the withholding tax creates some drag. But a TFSA still offers enormous benefits through tax-free growth and tax-free withdrawals. In many situations, that advantage outweighs the relatively modest impact of dividend withholding taxes.
For investors who want to completely avoid the withholding tax, the RRSP remains an option. However, the decision between using a TFSA or RRSP should generally be driven by your income level, retirement plans, and overall tax situation rather than a narrow focus on withholding taxes.
Personally, I think it is important not to let the tail wag the dog. In this case, withholding taxes are the tail. Long-term investment returns, tax-free growth, and disciplined saving are the dog.
