Your Complete Guide to Index Investing with Dan Bortolotti

The Wrong Way to Think About Withholding Taxes

2017-12-02T23:27:28+00:00January 30th, 2015|Categories: Taxes|Tags: |75 Comments

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.