When are tax-deferred and tax-free accounts actually taxable?
- U.S. stocks in TFSA
- U.S. stocks in RRSP
- Canadian stocks in RRSP
A. It’s great to hear we motivated you to start investing, Tawheeda. Stocks are a great way to build wealth for the long term, despite the short-run volatility. Tax plays a role in your portfolio construction and returns, so let me explain the implications.
Tax-free savings accounts (TFSAs) are mostly tax-free. When you buy and sell an investment for a profit, that is tax-free inside a TFSA, regardless of the type of investment.
One exception could be if you are day trading in your TFSA. If you are engaging in frequent trading activity, there is a risk your profits could become taxable as business income. For most long-term, buy-and-hold investors, this is not an issue.
U.S. stocks held in a TFSA are subject to 15% withholding tax on U.S. dividend income. The same would apply to other foreign stocks held in a TFSA, with rates starting at 15%, depending on the country. Only Canadian stocks are not subject to withholding tax on their dividends inside a TFSA.
Does this mean you should only hold Canadian stocks in your TFSA? Not necessarily. If your TFSA is your primary investment account, or a big part of your overall investments, you may need to hold non-Canadian stocks to have diversification. If it is a small part of your overall portfolio, you may be able to have a bias towards Canadian stocks in your TFSA, but that may or may not be the best investment strategy depending on the value and type of your other investment accounts. Canada is a small part of the global stock market and has little exposure to sectors like technology and health care, so foreign stocks help diversify and can increase risk adjusted returns.
Can you avoid foreign withholding tax by holding Canadian mutual funds or exchange traded funds (ETFs) in your TFSA, Tawheeda? Unfortunately, no. They, too, are subject to withholding tax on foreign dividend income, so even though you will not see withholding tax on your TFSA statement, the mutual fund or ETF itself would have withholding tax before receiving dividends from foreign stocks. TFSA withdrawals are always tax-free. However, if you over-contribute to your TFSA, in excess of your TFSA limit, you may be subject to a penalty tax and interest.
When you buy and sell for a profit in your Registered Retirement Savings Plan (RRSP), the proceeds are not generally subject to tax. The same business income treatment could apply to day trading in your RRSP, like your TFSA, but this would require frequent trading in your account.