The Tax-Free Savings Account (TFSA) is one of the best wealth-building tools available to Canadians. While that stands true for Canadian investments held in the account, there are some important considerations when it comes to TFSA U.S. investments.
Within a TFSA, capital gains from eligible U.S. stocks are sheltered from Canadian taxes. That being said, dividends paid by U.S. companies are still subject to U.S. withholding taxes before they hit your account.
The TFSA exemption stops at the Canadian border
Interest, dividends, and capital gains earned within a TFSA are generally not taxed by the Canada Revenue Agency (CRA). However, another country can still tax income generated there.
The U.S. applies a 15% withholding tax to dividends paid on U.S. stocks within a TFSA because the account isn’t recognized as a retirement account under the U.S.-Canada tax treaty.
That tax is deducted before the dividend hits the TFSA, and investors generally can’t recover it through a foreign tax credit because TFSA income is not reported on a Canadian tax return.
This means that an investor entitled to receive $100 in U.S. dividends may ultimately see only $85 deposited into their account.
This is different from the Registered Retirement Savings Plan (RRSP), which is recognized as a retirement account under the tax treaty.
Here’s where that dividend withholding problem appears
That dividend withholding issue relating to TFSA U.S. investments is best shown with an income-producing stock like Coca-Cola (NYSE:KO).
Coca-Cola has been paying dividends for decades and has earned its status as a Dividend Knight with over 60 years of annual increases. That makes it a popular long-term buy-and-forget option for investors.
That being said, Coca-Cola is a U.S. company paying U.S.-source dividends. Investors holding KO stock within a TFSA will lose approximately 15% of each dividend payment to withholding tax.
To be clear, investors can still benefit from that dividend income and dividend growth. But for investors looking to hold Coca-Cola stock with access to both a TFSA and RRSP, the RRSP is the more tax-efficient option.
Here’s a Canadian dividend alternative
One way to avoid the withholding issue is to consider a Canadian alternative such as Fortis (TSX:FTS).
Fortis is a utility stock that operates across Canada, the United States, and the Caribbean. A large part of its capital investment is directed toward its U.S. businesses.
Still, Fortis remains a Canadian corporation, and its TSX-listed shares can be held in a TFSA. This avoids the U.S. withholding issue with Coca-Cola entirely.
Fortis also offers a similar dividend growth streak to investors. The company has increased its dividend annually for 52 consecutive years, which is the second-longest streak in Canada.
The company also plans to increase its dividend by 4% to 6% annually through the end of the decade.
This makes Fortis a solid TFSA option for investors seeking steady dividend income without giving up part of every dividend payment to U.S. withholding tax.
Let’s talk about capital growth in a TFSA
U.S. growth stocks work differently within a TFSA, too. Amazon (NASDAQ:AMZN) is a great example of that difference.
Amazon doesn’t pay a dividend. Instead, the company reinvests cash into areas such as e-commerce, cloud computing, logistics, advertising, and artificial intelligence.
Without a dividend, there’s no recurring payment subject to U.S. withholding tax. Investor returns instead depend primarily on Amazon’s ability to grow its earnings and share price.
Capital appreciation generated inside the TFSA remains sheltered from Canadian tax. This means that from a withholding-tax perspective, Amazon can be a more efficient TFSA U.S. investment than a dividend-paying company like Coca-Cola.
The fine print should shape the portfolio, not scare investors
Canadians should not avoid U.S. stocks, even from within a TFSA. Instead, investors should find the best investments for the right accounts.
A Canadian dividend stock, such as Fortis, can provide income without U.S. withholding. A U.S. growth stock such as Amazon can deliver capital appreciation without a recurring dividend deduction. Meanwhile, Coca-Cola can still be a strong company, even if its TFSA dividends are slightly reduced.
The TFSA is one of the best investment vehicles for Canadian investors, provided they know the fine print. Understanding that hidden fine print makes it easier to decide which investments belong there.
