What NOT to Invest Inside Tax Free Saving Account

Since the introduction of Tax Free Saving Account (TSFA) in 2009, it has become one of the most popular ways to invest for Canadians. Every year, Canadians are allowed to invest up to $5000 into their TSFA. Any capital gain and any form of income such dividend, trust distribution, interest are all tax free. By compounding the returns without taxation, it is a great way for Canadians to build wealth.

Naturally the question of “what to invest in tax free saving account” becomes a very popular topic. There are many articles and researches out there to explore that topic. This article, however, attempt to address what NOT to invest or hold inside a TSFA account.

The truth is the Tax Free Savings Account isn’t always tax free. It really depends on the holdings inside the account. The name “tax free” can be misleading. I found about this the hard way. A few months ago, I bought preferred shares in a major US bank with good dividends inside my TSFA account. I noticed the dividend I received was less than what I expected. After checking with my broker, I realized a 15% of the dividend was withhold from my account. Needless to say I was not a happy camper.

Recently, with the strengthen of the Canadian dollar vs the US dollar, many Canadians like myself are interested in buying and holding US dividend paying company stocks inside their TSFA. While it’s a good way to diversify one’s stock portfolio, there is tax implication on collecting US dividend income inside the TSFA.

15% withholding tax on US dividends

Under US and Canadian tax treaty, a 15% withholding tax on dividends is automatically deducted on Canadian TSFA accounts by the brokerage firm. Although Canadian investor can file a US tax return later on to claim some of the tax back, it is still not fully tax free, not to mention the opportunity cost to have those dividend reinvested in other investments.

RRSP and TSFA are taxed differently

On the other hand, there is no withholding tax on dividend income inside Canadian RRSP (Registered Retirement Savings Plan). Even though TSFA and RRSP are both registered accounts, there are major difference in terms of tax treatment when holding US stocks and bonds. This is because under the tax treaty between US and Canada, only retirement accounts are exempt from the withholding tax. TSFA is not treated as a primary retirement investment vehicle.

Besides US withholding tax implications, there could be more tax consequences for holding other foreign stocks.

In summary, Canadian investors need to be careful on what to invest inside the TSFA. If one wants to keep TSFA truly tax free, it is best to keep things simple by not holding any foreign securities.

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