The Wrong Way to Think About Withholding Taxes

If you live in a big city, you can save a few cents per litre on gas by travelling to the boonies. But you also understand that it doesn’t make sense to burn $10 of fuel driving out of town so you can save $8 on a fill-up. Yet many investors seem to be making a similar error by trying to avoid foreign withholding taxes in their registered portfolios.

About a year ago, Justin Bender and I co-wrote a white paper that estimated the cost of foreign withholding taxes. There are far too many details to review here, but among the most important is that withholding taxes on dividends are lost if you hold a Canadian mutual fund or ETF of foreign stocks inside an RRSP or TFSA. If you hold the same fund in a non-registered account, however, you can recover the withholding taxes by claiming a credit on your tax return.

Sometimes I feel like we created a monster with this paper, because I have received many e-mails from readers who have misunderstood this information and made poor decisions as a result.

Here’s an example: Cyril wants to build a balanced portfolio that includes US and international equities, and he wants to use only Canadian-listed ETFs. Having read our white paper, Cyril knows that if he uses an ETF such as the Vanguard US Total Market (VUN) in an RRSP or TFSA, it will incur a 15% withholding tax on the dividends. So although he has plenty of contribution room in his tax-sheltered accounts, Cyril decides to hold his US equities in a non-registered account so he can recover that withholding tax.

That might sound wise, but it’s like driving a hundred miles out of your way to buy cheaper gas. Cyril’s decision would avoid a small withholding tax on dividends while opening him up to Canadian income taxes on the fund’s total return.

Save a little, pay a lot

Let’s assume Cyril’s portfolio includes a $10,000 holding in VUN, and that the yield on the fund is 2%. The ETF would pay $200 annually in dividends, resulting in withholding taxes of $30. This would be lost in an RRSP or TFSA, but recoverable in a non-registered account. But you can’t stop there.

If Cyril holds the fund in a non-registered account, he will need to report the full $200 as foreign income and it will be taxed at his full marginal rate. Assuming an average income, his marginal rate is likely about 30%, or more than double the rate of US withholding tax. What’s more, any capital gains on the ETF will eventually be taxable—at half his marginal rate—when they are realized.

All of which is to say, in the vast majority of cases Cyril’s overall tax bill is going to be significantly lower if he holds his US equity fund in a tax-sheltered account. And that doesn’t even factor in the tax deduction Cyril would receive by making a contribution to his RRSP.

Counting the cost

You may have noticed something else in the comparison above. The total impact of foreign withholding tax on Cyril’s $10,000 holding was just $30. When investors hear “you’re subjected to a 15% tax” it can sound dramatic, but in dollar terms it may not be much at all. On a five-figure portfolio, foreign withholding taxes should not be a primary concern.

Consider another young investor, Lana, who has $36,500, enough to max out her TFSA. She’s decided to keep 50% of her portfolio in US and international equities, but she’s worried that foreign withholding taxes will erode her returns. If we assume international equities yield about 3% and the average withholding tax is 10%, it turns out the cost is also about $30 per $10,000 invested, the same as for US equities. So the total impact of foreign withholding taxes on Lana’s TFSA would be about $55 a year. That’s not negligible, but it’s probably a lower number than you expected. And it’s clearly not a reason for Lana to avoid getting global diversification.

So let’s be clear: most investors should take full advantage of tax-sheltered accounts before investing in non-registered accounts, period. While there are exceptions to this rule of thumb, none of them have anything to do with avoiding foreign withholding taxes.

 

75 Responses to The Wrong Way to Think About Withholding Taxes

  1. George April 29, 2015 at 12:01 pm #

    One thing I haven’t really seen discussed on any blogs – let’s assume you put your Canadian stocks in your TFSA, and your US stocks in your RRSP to eliminate withholding taxes. Let’s say you have decided you want 50/50 allocation between Canadian and US stocks. When it comes to rebalance, what exactly does that mean in dollar terms? Of course you convert to CD$ to calculate the allocations, but even then I don’t think you can consider CD$1 in your TFSA to be equivalent to CD$1 in your RRSP, because one is after tax money and the other is before tax.

    In my planning, I ‘haircut’ the value of my RRSP for the purposes of rebalancing, i.e. reduce it by an estimate of my tax rate in retirement. So if I estimate 25%, then my portfolio is ‘balanced’ 50/50 when I have $7,500 of Canadian stocks in my TFSA and $10,000 of US stocks in my RRSP.

    Interested if others take this into account at all. Clearly guessing your marginal tax rate in retirement is far from precise, but it seems to me that any value around 20-30% is probably a better estimate than the 0% that you are implicitly assuming if you ignore this effect entirely.

  2. Canadian Couch Potato April 29, 2015 at 12:33 pm #

    @George: This is a great question and it’s one that has been pondered before. The problem is that it is very difficult to manage a portfolio that way, both practically and behaviorally. Do you rebalance the portfolio whenever your expected tax bracket in retirement changes? If your RRSP falls in value by 30%, does it really make you feel better knowing that some of that money belonged to the government? And let’s imagine you’re 20 years from retirement and you hold $40,000 of stocks in your TFSA and $40,000 of bonds in your RRSP. Now imagine that you sold everything and repurchased the stocks and bonds in the opposite accounts. Have you really fundamentally changed your situation?

    This may be of interest:
    http://www.retailinvestor.org/rrsp.html#aa

    If you have a detailed financial plan in place, the income projections take into account the fact that RRSP withdrawals are taxed and TFSA withdrawals are not, so it’s not fair to say that this issue is completely ignored (as some have suggested).

  3. Tnerb May 1, 2015 at 10:17 am #

    Hi CCP, I’m about to start a portfolio and I kind of just wanted a quick confirmation that my plan doesn’t have any glaring flaws.

    I’m 24 and I have about $15k ready to invest. My plan was to basically follow your “option 3” (The ETF option) of your model portfolio with either the “assertive” or “aggressive” weightings and have all of it in a TFSA.

    I guess the only other kicker is that I am planning on putting a down payment on a house soon, I may withdraw some of this money (which is why I have that money just sitting around anyway).

    So a few quick questions:

    1) Am I right in thinking that 100% of this should be in a TFSA? Especially considering the potential withdrawal coming up?

    2) Any benefit to replacing some VCN or VXC with some VUN? VUN seems to out perform at least VCN pretty significantly and I’m not sure I entirely see the rationale in having so much in VCN, at least for someone my age.

    Thanks.

  4. Canadian Couch Potato May 2, 2015 at 9:33 am #

    @Tnerb: If you are planning to use these funds as a down payment within the next three years or so, an aggressive or assertive portfolio is not appropriate. Equities are only suitable as a long-term investment, not for short-term savings. Short-term savings should be kept in cash or GICs. That’s the number one issue to address. If you are planning to save for a down payment, then a TFSA is fine, as any withdrawals can be replaced later.

  5. Yan May 6, 2015 at 7:14 pm #

    I know that the 15% withholding tax on dividends is quite a bit lower than the marginal tax rate most people would need to pay if VUN were to be held in a non-registered account. Having said that though, I’m just curious why you recommend VUN over an ETF that directly holds US equities like ZSP for registered accounts? I was under the impression that the Canada-US tax treaty allows investors to keep withholding taxes in registered accounts when investing in ETFs that directly purchases the US stocks. I know they’re different indices but for the average investor looking for US equity exposure, an ETF that tracks the S&P 500 would likely suffice would it not?

  6. Canadian Couch Potato May 6, 2015 at 10:12 pm #

    @Yan: There is no tax advantage to Canadian-listed ETFs that hold US stocks directly vs. those that hold an underlying ETF. In both cases, withholding taxes are recoverable in a non-registered account and lost in an RRSP/TFSA. The only way to be exempt from the withholding taxes in an RRSP is to hold a US-listed ETF.

    http://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/

  7. Omar June 16, 2015 at 1:08 pm #

    My apologies if this has been covered before. Are withholding taxes automatically deducted even if I hold US$ securities in RSP account? If so, do I need to fill out a form (W-8BEN?) to reclaim these? Any help in this matter would be greatly appreciated.

  8. Canadian Couch Potato June 16, 2015 at 1:25 pm #

    @Omar: Withholding taxes should not be deducted automatically if you hold US securities in an RRSP. If they were, I am not aware of any way to reclaim. But it is still a good idea to fill out a W-8BEN through your brokerage to be on the safe side.

  9. Alice March 4, 2016 at 5:17 pm #

    Do other registered accounts like RESP, RDSP are also exempted from the foreign withholding tax? thanks

  10. Canadian Couch Potato March 4, 2016 at 5:31 pm #

    @Alice: Unfortanately, no. Only retirement accounts qualify for the exemption.

  11. cam March 7, 2016 at 1:30 pm #

    Sorry for the late question — I’ve been thinking about this recently and notice there is still interest and activity on this thread. I’m wondering, does any of this apply to the capital gains component? Is it only the dividend witholding tax that is the consideration?
    Conceptually, if one were to seek out at US-listed ETF that pays low dividends, would there be any capital gains consequences when this is eventually sold? There are probably other problems with diversification, additional trading, etc, but has been a curiosity of mine and I haven’t been able to find a lot of info.

  12. Canadian Couch Potato March 7, 2016 at 1:42 pm #

    @Cam: Capital gains on US-listed ETFs are taxed in the same way as Canadian ETFs. No withholding tax issues. However, the book value and sale price must be calculated using CAD, which makes the bookkeeping more complicated and is another reason to avoid US-listed ETFs in taxable accounts.

  13. cam March 7, 2016 at 3:55 pm #

    @CCC: I was thinking moreso about whether there would be any US witholding for capital gains inside the TFSA. Inside the TFSA, if I buy Canadian-listed ETFs, it’s clear that there would be no tax on dividend income or growth, but if I buy US-listed ETFs, is it only the dividend income portion that would be taxed, or would the US government require taxes paid on the growth portion as well?

    Also, regarding bookkeeping requirements for US listed ETFs in taxable accounts: I have read alternate recommendations that suggest that foreign currency contributions & withdrawals should only be made in cash to/from taxable accounts, to simplify bookkeeping to the daily noon exchange rate. If we avoid contributing shares in kind, is it only the currency contribution and withdrawal that need to be converted to CAD?

    I do hold US-listed ETFs outside my taxable accounts, and you’re correct, an additional complication is added to track the book value back to CAD funds. For myself, this seems a much simpler problem than the much more complicated adjusted cost base calculations for all ETFs in the taxable accounts. After reading your ACB Case Study article at http://canadiancouchpotato.com/2014/06/27/ (and those linked to it), I haven’t yet found a bank that reported this correctly.

  14. Canadian Couch Potato March 7, 2016 at 4:03 pm #

    @cam: There is no withholding tax by the US on any capital gains that are realized in a TFSA. The only withholding tax is on distributions from the funds.

    Regarding calculating ACB on US securities, this may help:
    http://www.moneysense.ca/invest/calculating-capital-gains-on-u-s-stocks/

  15. Danny March 20, 2016 at 1:20 am #

    do you think this is a good allocation of assets for someone who doesnt have an RRSP:

    TFSA: US dividend stocks, Bonds
    Non-registered: Canadian dividend stocks

  16. Canadian Couch Potato March 20, 2016 at 4:40 pm #

    @Danny: If your TFSA is full and you don’t have an RRSP, then yes, it makes sense to keep the Canadian stocks in the non-registered account.

  17. Ari March 21, 2016 at 12:07 pm #

    @CCP Canadian equities accounted for 2.5% of the global equity market, while Canadian fixed income accounted for 2.4% of the global bond market as of December 31, 2015.

    Why Vanguard recommends to have Market-Cap Weighted Portfolio.
    See here model portfolios – https://www.vanguardcanada.ca/individual/etfs/portfoliostrategies.htm

    In the Fixed Income it has only VBU and VBG nothing on Canadian Bond VAB.

    But CCP model portfolio has only VAB. What is the advantage and disadvantage? I am new to investment and little confused why there is a bias on the Canadian investment? Shouldn’t we go by the Market-Cap Weighted Portfolio?

  18. Canadian Couch Potato March 21, 2016 at 12:24 pm #

    @Ari: The Vanguard link actually has the market-cap weighted portfolio as only one of several suggestions (the other tabs have model portfolios with more Canadian exposure). These should help explain the logic behind my model portfolios:
    http://canadiancouchpotato.com/2012/05/22/ask-the-spud-does-home-bias-ever-make-sense/
    http://canadiancouchpotato.com/2014/08/29/ask-the-spud-should-i-use-global-bonds/

  19. Ari March 21, 2016 at 5:02 pm #

    @CCP Great Info! Thanks.

  20. Koen December 3, 2016 at 1:38 pm #

    Hi Dan,
    I read your article and white paper about foreign withholding taxes. I started investing via Questrade a couple of months ago following Justin’s PWL model ETF portfolio (with VAB, VCN, VUN, XEF and XEC ETF’s).
    I understand that foreign withholding taxes apply to some or all of these ETF’s but I don’t remember filling out the W-8BEN form discussed in your white paper to only pay 15% in taxes instead of 30%. Does this form no longer apply to only pay the 15% or do I need to contact Questrade and ask for this from when only holding these 5 ETF’s in an TFSA, RRSP and RESP?

    Thanks.

  21. Canadian Couch Potato December 3, 2016 at 1:49 pm #

    @Koen: Many brokerages complete the W8-BEN on your behalf and submit it to the IRS. In any event, it is only relevant if you hold US securities, so if you are using Justin’s ETF model portfolio it’s unnecessary. You won’t pay the 30% withholding tax: you’ll pay whatever percentage applies at the fund level (15% for the US dividends, usually less for international).

  22. Sam January 7, 2017 at 4:08 pm #

    Hello,
    Thanks for the article, greatly appreciated. The real life examples made this much easier to understand. I’m currently trying to understand the best way to handle a situation like this. I currently have about 4K (USD) invested in a US equity stock called Blackstone (BX). I’m trying to determine if I’d be better off moving this into my TFSA instead, and paying the 15% withholding tax, vice trying to recoup it only to get charged the full marginal rate of 26% as I make over 91K a year. Any assistance or advice you can provide on this would be greatly appreciated. Also, will my bank provide me with all the information I need to do my taxes, or will need to go hunting for various items?

    Thanks!

  23. Canadian Couch Potato January 7, 2017 at 4:48 pm #

    @Sam: As with all similar decisions, the answer is “it depends.” Is your TFSA maxed out? If not, then it is always better to hold investments in a TFSA than a non-registered account. If it is maxed, then you would need to sell something to free up the cash to buy the stock you want. And if you do that, are you going to repurchase that asset in a taxable account?

    Your brokerage will send a T5 slip for the stock if it is held in a non-registered account. The slip will tell you how much dividend income you need to report on your taxes.

  24. Sam January 9, 2017 at 5:15 pm #

    Hello, my TFSA isn’t maxed out so I’ll probably move my investment there. I’ll speak with my bank about getting the T5 slip. Thanks for the insight and advice, greatly appreacited!

  25. Jim R January 9, 2017 at 6:12 pm #

    @CCP
    Somewhat off topic, but I thought brokerages hold on to W8-BENs and W9s. It’s only if the IRS has an issue of some sort that the brokerage may forward the form to the IRS.

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