Canadians: 5 Points to Consider About US Dividends

Before you load up, beware of tax, currency conversion, and other considerations, writes John Heinzl, reporter and columnist for Globe Investor.

Canada is a great place for dividend lovers. We've got terrific banks, utilities, telecoms, and pipeline companies that raise their dividends regularly.

But if we want exposure to some of the world's top consumer, technology, and health-care companies, we'll need to do some cross-border shopping. The US market is brimming with dividend stalwarts, some of which—Procter & Gamble (PG), Wal-Mart (WMT), Johnson & Johnson (JNJ), and McDonald's (MCD), to name a few—have been raising their dividends for decades.

But before you load your shopping cart with US stocks, here are some things to keep in mind.

Mind the Taxes
US dividends don't qualify for the Canadian dividend tax credit, so if you hold your US stocks in a non-registered account, you'll pay tax at your full marginal rate.

What's more, in a non-registered account, you'll face a 15% US withholding tax on the dividend. You can usually recoup this amount as a foreign tax credit on your return, but the bottom line is that most people will end up paying the same tax rate on US dividends as they do on interest or other income.

Choose Your Account Carefully
You can avoid taxes on US dividends if you hold your US stocks in a retirement account, such as (in Canada) a registered retirement savings plan (RRSP), registered retirement income fund (RRIF), or locked-in retirement account (LIRA). That's because, under the Canada-US tax treaty, accounts that provide retirement or pension income are non-taxable.

But be careful. Many people assume that if they hold US stocks in a tax-free savings account (TFSA) or registered education savings plan (RESP), they will avoid taxes on their dividends. Not true. Because TFSAs and RESPs are not retirement accounts, the 15% withholding tax still applies and cannot be recovered.

Watch Currency Conversion Costs
If you're using Canadian cash to buy a US stock, your broker will first convert your money into US greenbacks—at an exchange rate that is favorable to the broker, of course.

When you sell your US stock, if it's a registered account the broker will often convert the US proceeds back to Canadian dollars—costing you money yet again.

How much money? I did some hypothetical currency conversions with my own discount broker, and here's what I found. On Monday (when the Canadian dollar was trading slightly above par), if I had sold $5,000 (Canadian), I would have received $4,940.71 (US). If I had then converted that $4,940.71 (US) back to loonies, I would have received $4,841.89 (Canadian).

So, on the currency transactions alone, I would have been down $158.11, or about 3.2% of the initial $5,000. Ouch. But the good news is that there are ways to minimize the hit to your portfolio.

With registered accounts, brokers used to automatically convert US dividends, and the proceeds of US stock sales, into Canadian dollars. But a growing number of discount brokers now let you accumulate US cash in registered accounts, without forced conversion. This is a plus, because if you reinvest your US cash in US securities, you can avoid conversion costs.

Brokers that provide this option include RBC Direct Investing, BMO InvestorLine, Qtrade, Questrade and Virtual Brokers. Ask your broker about its policy.

Another benefit is that, if you intend to convert the money to Canadian dollars, you can wait until the exchange rate is favorable. Alternatively, if you plan to travel in the United States in retirement, you can withdraw the US funds from your RRIF when you need them.

Consider ETFs
If choosing individual stocks makes you nervous, there are numerous exchange-traded funds that invest in US dividend stocks. These ETFs have low management expense ratios and provide broad diversification.

Examples include the Vanguard Dividend Appreciation ETF (VIG), WisdomTree Total Dividend ETF (DTD), and SPDR S&P Dividend ETF (SDY).

Bear in mind that, if the loonie appreciates, your US stocks or ETFs will be less valuable in Canadian dollars. Conversely, if the loonie falls, you'll benefit.

Investors can hedge their exposure with currency futures and other products. A simpler option is to buy a Canadian-traded ETF with built-in currency hedging, such as the S&P US Dividend Growers Index Fund (Toronto: CUD) or the BMO Dow Jones Industrial Average Hedged to CAD Index ETF (Toronto: ZDJ).

Be warned, however, that taxation of Canadian-listed ETFs that hold US stocks is complex, as the Canadian Couch Potato blog has pointed out.

Complicating matters further, hedging is not an exact science, and there are costs involved. With the Canadian dollar already trading at a premium to the US buck, some investors believe that the risks of a substantial advance in the loonie are minimal, so they're happy to leave their US stocks or US ETFs unhedged.

Watch Your Weight
One way to make sure that currency swings won't have a huge impact—positive or negative—on your portfolio is to limit your US exposure.

For example, I keep my US stocks to less than 10% of my portfolio. That allows me to hold a diversified collection of great dividend companies, without losing sleep over the direction of the Canadian dollar.