How Best To Minimize Withholding Taxes On U.s. Stocks — In An Rrsp Or A Tfsa?

Q. I have been reading about holding U.S. stocks in a tax-free savings account (TFSA), and how this could be problematic due to U.S. withholding taxes. I still have contribution room in my registered retirement savings plan (RRSP). Should I move my U.S. blue chip stocks from my TFSA to RRSP? Would this be beneficial tax-wise for me? Many people seem to say, “It depends.” Depends on what? Can you please explain? —Shila P.

FP Answers: I agree that the decision to move these stocks does depend on several factors, Shila. If you receive a U.S. dividend in your TFSA, there is withholding tax of 15 per cent that comes right off the dividend when it is paid. There is no tax relief, as the IRS does not recognize the TFSA as a tax shelter. They do recognize RRSPs, and U.S. dividends do not have withholding tax in an RRSP as a result. Since TFSAs are not taxable to non-U.S. citizens such as Canadian residents, the ability to recover withholding tax by claiming foreign tax credits on your tax return is not available.

The S&P 500 index has a trailing 12-month dividend yield of about 1.25 per cent. This is a reasonable proxy for the average dividend for a U.S. stock. If 15 per cent is withheld from that 1.25 per cent yield, you would have a reduction of about 0.1875 per cent from the total return. This is arguably one of the costs an investor must pay to achieve diversification in their portfolio.

If you hold U.S. stocks, or managed products that earn U.S. dividends, you could avoid the withholding tax by isolating these to your RRSP. Canadian stocks do not have this same treatment and are not subject to withholding tax on dividends in any registered accounts.

Keep in mind that Canadian domiciled exchange-traded funds (ETFs) and mutual funds that hold U.S. securities will be subject to the withholding tax on dividends in any account. So, if you would like to avoid withholding tax on U.S. dividends, owning U.S. domiciled/listed ETFs and stocks in your RRSP would be the way to go.

A simple strategy to consider if the withholding tax is a concern to you, Shila, is to hold Canadian stocks in your TFSA and U.S. stocks in your RRSP to avoid withholding tax altogether. This may not be the ideal strategy from a diversification standpoint if one stock market performs significantly better than the other, but it is simple, and would solve part of your concern.

Organizing your portfolio assets to take advantage of how the investments are taxed in different accounts refers to tax location planning. Most people tend to hold multiple asset classes in each account rather than isolating assets based solely on tax, so it is not common to employ tax location strategies, especially when most investors have all assets held in TFSAs and RRSPs. Some may have non-registered or corporate or trust accounts, but many investors have only an RRSP. The issue with a sole focus on tax location is that there are further implications to consider outside of what happens annually from a tax standpoint, such as where you hold your growth versus income assets and what is your overall tax and cash flow timing situation.

For example, putting your U.S. stocks in an RRSP could avoid withholding tax on dividends, but if these investments have a higher potential for growth, perhaps you would prefer them in the TFSA. The growth, income and withdrawal are never taxed, beyond the 15 per cent withholding tax on the dividends.

Another point is that many U.S. growth stocks, especially in the mega- and large-cap space, have lower dividends, or don’t pay dividends at all. As a result, these could be isolated to your TFSA. You could then hold U.S. stocks paying higher dividends in your RRSP to reduce your worries about the withholding tax.

If you have RRSP room and you have money in your TFSA, Shila, you should consider whether making RRSP contributions makes sense regardless of which investments you intend to own. If your income is relatively high, particularly if it is likely to be lower in retirement, using TFSA withdrawals to fund your RRSP contributions can make sense. You can get a tax refund and turn $10,000 of TFSA investments into $10,000 in your RRSP and a $2,000 to $5,000 tax refund, depending on your income level and where you live in the country.

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As with any investment decision, no single factor should determine how you invest. Focusing too much on tax could cost you more than you save. Thankfully, TFSAs and RRSPs offer tax sheltering and deferral that, if used properly, can help you keep more of your savings through your working years and into retirement. For what it’s worth, many portfolio managers focus more on providing the best risk-adjusted returns with tax planning being a secondary consideration, if at all.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.