The Tax-Free Savings Account (TFSA) is one of the best investing accounts Canadians have, but the name comes with some fine print. Generally, interest, dividends, and capital gains earned inside a TFSA are tax-free in Canada, and withdrawals are tax-free as well. However, foreign governments do not necessarily recognize the account the same way the Canada Revenue Agency (CRA) does.
That creates one mistake I see Canadian income investors make repeatedly: loading a TFSA with high-yield U.S. dividend stocks. U.S. dividends paid to Canadian residents generally benefit from a treaty-reduced 15% withholding rate rather than the normal 30% rate. Inside a TFSA, though, the withholding tax generally cannot be recovered.
For a low-yielding growth stock, I would not worry much about it. But once you start chasing 5%, 7%, or even higher U.S. dividend yields, the drag becomes much more noticeable.
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What a 5% yield actually becomes
Suppose you buy a U.S. dividend stock yielding 5%. A 15% withholding tax means you lose 0.75 percentage points of that yield before the dividend reaches your TFSA. Your effective yield therefore falls from 5% to about 4.25%.
On a $100,000 position, a 5% yield would normally generate $5,000 annually. After 15% withholding, you would receive about $4,250, with roughly $750 lost each year. Over a long holding period, the effect becomes larger because that missing income also cannot be reinvested and compounded.
The important distinction is that the withholding applies to dividend income, not the capital appreciation of the stock itself. If the shares rise substantially and you eventually sell them inside your TFSA, those gains remain tax-free in Canada.
That is why I am much less concerned about holding low-yielding U.S. growth stocks in a TFSA than I am about using the account specifically to build a high-yield U.S. income portfolio.
Why the RRSP can be a better home
For U.S.-dollar dividend investments, the Registered Retirement Savings Plan (RRSP) generally has an important advantage. The Canada-U.S. tax treaty recognizes qualifying RRSP retirement arrangements differently. U.S. dividends and interest derived by an RRSP can generally receive an exemption from U.S. tax, eliminating the 15% dividend withholding that normally applies inside a TFSA.
That can make asset location fairly straightforward for investors who already use both accounts. I would generally favour putting high-yielding U.S. dividend stocks and U.S.-listed income exchange-traded funds (ETFs) inside the RRSP, while reserving TFSA space for Canadian investments or U.S. stocks where most of the expected return comes from capital appreciation.
There are still broader considerations. RRSP withdrawals eventually become taxable income, whereas TFSA withdrawals remain tax-free. Your tax bracket today and expected tax bracket in retirement matter far more than saving a fraction of a percentage point in withholding tax. But if you already intend to own a high-yield U.S. dividend investment, the RRSP is usually the cleaner place for it.
