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 himself 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 $55 a year. That’s not negligible, but it’s probably a lower number than you expected. And it’s clearly not a reason for Lana to avoid getting global diversification.
So let’s be clear: most investors should take full advantage of tax-sheltered accounts before investing in non-registered accounts, period. While there are exceptions to this rule of thumb, none of them have anything to do with avoiding foreign withholding taxes.
One thing I haven’t really seen discussed on any blogs – let’s assume you put your Canadian stocks in your TFSA, and your US stocks in your RRSP to eliminate withholding taxes. Let’s say you have decided you want 50/50 allocation between Canadian and US stocks. When it comes to rebalance, what exactly does that mean in dollar terms? Of course you convert to CD$ 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.
@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).
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.
@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.
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?
@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.
https://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/
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.
@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.
Do other registered accounts like RESP, RDSP are also exempted from the foreign withholding tax? thanks
@Alice: Unfortanately, no. Only retirement accounts qualify for the exemption.
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.
@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.
@CCP: 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 https://canadiancouchpotato.com/2014/06/27/ (and those linked to it), I haven’t yet found a bank that reported this correctly.
@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/
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
@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.
@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?
@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:
https://canadiancouchpotato.com/2012/05/22/ask-the-spud-does-home-bias-ever-make-sense/
https://canadiancouchpotato.com/2014/08/29/ask-the-spud-should-i-use-global-bonds/
@CCP Great Info! Thanks.
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.
@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).
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!
@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.
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!
@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.
Dan, thank you for your insightful advice. I would like to clarify one point. I understand that there is withholding tax by the US on distributions from US funds held in TFSA. I understand that there is no withholding tax on any capital gains that are realized in a TFSA. However, is there any other tax applied to capital gains realized upon disposition of US assets within a TFSA?
@okianus: No, capital gains from selling US assets (or any other kind of assets) are not subject to any tax in a TFSA.
Hi Dan, thanks a lot for the information you share here. I’ve just started the investment by buying some ETFs in my TFSA (that is not maxed at all).
I was thinking of buying some bonds in my portfolio, something like XIG. But I read in your other article that it is unwise to hold US bonds inside the TFSA. Does it mean that it’s better not to have them at all and to buy just Canadian bonds, if I don’t have RRSP ? Any assistance or advice you can provide on this would be greatly appreciated.
@Veronika: There’s nothing specifically wrong with holding bonds (US or otherwise) in a TFSA if you don’t have an RRSP. But it is generally better to stick with a Canadian bond ETF.
It sounds like in your situation a one-fund ETF portfolio would be ideal. These include both equities and bonds with no rebalancing required, which is perfect for small accounts.
hi
I have room in my TFSA and RRSP. speaking from a tax efficiency perspective, is it better to hold US bonds in my RRSP vs. by TFSA?
@confused: There should be no withholding tax on interest from US bonds, so RRSP v. TFSA would likely make no difference from that perspective.
So glad this thread is still semi active! I currently have my RRSP and TFSA (both maxxed out) with Questwealth Portfolios by Questrade. I have recently opened a non-registered Cash account as well (as I still had money left over to invest). The portfolios are prebuilt and I am in Growth for my RRSP and Aggressive for both the TFSA and the Cash accounts. Do I need to worry about the W8-Ben at all? No one from Questrade has indicated that I need to fill this out!
I am planning to invest my kids RESP in S&P500 but I am a dilemma whether to choose Canadian ETFs VFV/VSP or USA ETF VOO/SPY. If I choose USA ETF I need to pay the 15% withholding tax on dividends. Can you explain me which will suit my needs?
@Chandrasekhar: There is no way to avoid foreign withholding taxes in an RESP. You will pay them whether you use Canadian-listed or US-listed ETFs. For that reason, it is usually better to transact in Canadian dollars in a RESP.
Thanks for your reply, so which one do you recommend VFV/VSP or any other ETF
Thanks for the update, can you suggest good fund to invest for RESP
Hello I am 22 and I am looking to begin investing into either VTI or VUN in my TFSA and RRSP. I plan on maxing both of them out each year as I have finished University and have landed a full time job through my coop/internship experience. I will format my questions in scenarios. So lets say I purchase VTI or VUN is the withholding tax automatically deducted from the dividend/distribution yield because the dividends are automatically reinvested? Or if not how does the reinvesting of dividends get affected? If I purchase VTI is the withholding tax taken off the US currency and for VUN the 15% would be based on the CAD currency. Also which ETF in the long term has more potential upside as VUN has an MER of .16%, but VTI has an MER of .03% (but I incur the conversion cost of CAD to US which is usually between 1.5-2%). Thoughts??
@Nick: There is definitely no advantage to using VTI (or any US-listed ETF) in a TFSA. I would always recommend Canadian-listed ETFs in TFSAs. In an RRSP, US-listed ETFs can make sense for larger accounts, though only if you are contributing US dollars or converting CAD cheaply (i.e. with Norbert’s gambit). For investors just getting started, it’s usually not worth it.
As for how the withholding taxes are deducted, here’s how it works in simplified terms:
– in an RRSP, no withholding tax is deducted from VTI’s dividends. A $100 USD dividend is paid to you as $100 USD.
– if you were to hold VTI in a taxable account or TFSA, the dividends are paid in USD with 15% withheld by the brokerage (not by the fund). A $100 USD dividend is paid you as $85 USD.
– in all account types, the withholding tax on dividends from VUN is withheld at the fund level. The remainder is paid in CAD. A $100 US dividend is reduced to $85 USD and paid you in CAD at the prevailing exchange rate.
If I can offer some general advice, your priority now should be saving and investing in a low-cost diversified portfolio, without trying to “optimize.” I spend much of my book, Reboot Your Portfolio, trying to stress this point!