The Fine Print Most Canadians Miss When Holding U.S. Stocks in a TFSA

Maximize your investment opportunities in US stocks with a TFSA while being aware of the tax implications of dividends.

Key Points
  • Tax Implications of Holding U.S. Stocks in a TFSA: While U.S. stocks can be held in a TFSA, dividends are subject to a 15% withholding tax due to the U.S.-Canada tax treaty, although capital gains remain tax-free.
  • Strategies for Tax-Efficient U.S. Stock Exposure: Canadians can utilize Canadian Depository Receipts (CDRs) or hedged U.S. ETFs like the iShares NASDAQ 100 Index ETF (TSX:XQQ) to invest in U.S. stocks through a TFSA, thereby optimizing the tax benefits while participating in growth sectors like AI.

The U.S. is the world’s biggest stock market where many attractive dividend and growth stocks trade. From Micron Technology to Pfizer, you can get exposure to global leaders of various profit-making sectors. The Canada Revenue Agency (CRA) allows Canadians to buy US stocks trading on the Nasdaq and NYSE through the Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP). However, the tax benefits of a TFSA come with fine print when holding US stocks.

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The fine print of holding U.S. stocks in a TFSA

You can earn from a stock through capital appreciation or dividends. Both fall under different tax brackets. The Internal Revenue Service (IRS) taxes dividends as “Income from Other Sources”. When a non-resident American earns this income, the IRS imposes a 30% withholding tax before crediting the dividend to the beneficiary’s account. Thanks to the US-Canada tax treaty, Canadians face a 15% withholding tax provided they submit the necessary forms with their broker and claim the benefit.

The capital appreciation falls under capital gains tax. This tax is paid by the non-resident in their resident country. In Canada, TFSA investments are allowed to grow tax-free. Thus, if you hold US stocks in a TFSA, you are subject to the IRS’s 15% withholding tax on dividends but benefit from the CRA’s tax-free capital gain.

However, the IRS allows dividends to grow tax-free in an RRSP, as it is a retirement account.

The TFSA only accepts Canadian dollar values

Another fine print point to note for a TFSA holding US stocks is that all values have to be converted into Canadian dollars. The CRA determines TFSA contribution room in Canadian dollars, and even if you invest in US stocks, you have to ensure the investment does not exceed the Canadian dollar limit.

Non-residents cannot invest in a TFSA

Now, if you work in the United States and become a non-resident in Canada, because you stayed 183 days or more out of Canada in a tax year, you cannot invest in a TFSA. The TFSA benefit is only for Canadians. Any contributions made as a non-resident would attract a penalty of 1% per month. As a non-resident, you can’t even accrue new contribution room.

So be careful where you invest in US stocks and know your tax residency before investing through a TFSA.

How to get exposure to US stocks through a TFSA in a tax-efficient manner?

Navigating the fine print, a tax-efficient way to get exposure to US stocks in a TFSA is to buy Canadian Depository Receipts (CDRs) of US stocks. With CDRs, you can buy fractional shares of global tech companies on Canadian exchanges in Canadian dollars. CDRs remove the hassle of currency conversion and hedge your exposure to exchange rate fluctuations. Companies like Micron, SpaceX, and Broadcom have their CDRs listed on the TSX.

Another tax-efficient way to get US stock exposure is through US ETFs trading on the TSX and currency hedged. The iShares NASDAQ 100 Index ETF (CAD-Hedged) (TSX: XQQ) replicates the Nasdaq 100 Index and charges a minimal management fee of 0.35% annually. It calculates the fee on your total investment, irrespective of the performance. If you invest $10,000 in the first year, $35 is charged. If your investment grows to $20,000 in the third year, $70 is charged. This fee is not charged separately but is adjusted to your net asset value.

However, the XQQ ETF’s 39% year-to-date return and 20% average annual return in 10 years make the fee a drop in the ocean. In fact, it is a cost-efficient way to benefit from the artificial intelligence (AI) sector. All AI players trade on the Nasdaq, from AI chipmakers to AI application developers, and AI infrastructure providers. Nasdaq will not only capture the AI revolution but all future tech revolutions like self-driving cars, space travel, and robotics.

Investing tip

The TFSA is a great investment tool as it lets your money grow tax-free. A stock that can grow multiple-fold and help with wealth creation is best placed in a TFSA, as it can save you a significant amount in tax, especially if you fall under a higher tax bracket.

Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool recommends Broadcom, Micron Technology, and Pfizer. The Motley Fool has a disclosure policy.

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