Finding the Right Vehicle for US Investing

01/31/2011 12:41 pm EST

Focus: MARKETS

Rob Carrick

Columnist, The Globe and Mail

US dividend stocks offer some interesting possibilities for income-seeking investors, says Rob Carrick, columnist for The Globe and Mail.

Invest in the USA with your TFSA?

US dividend stocks offer some interesting possibilities for income-seeking investors, and now’s an opportune time to buy them because the Canadian dollar is at parity with the US buck. But what’s the right investing vehicle for the likes of AT&T, Merck, Johnson & Johnson, Intel, and McDonald’s, all of which yield more than 3.3%?

Tax-free savings accounts are fine for US dividends in the short term, and long-term investors will find they work quite well to minimize taxes. Registered retirement savings plans look good for US dividends in the short term, but they may be less attractive over the long term from a tax point of view. And then there’s the non-registered account, with its own pluses and minuses.

This edition of Portfolio Strategy aims to provide some ideas for dividend investors on how to handle US and international stocks. Let’s call it the Where to Put What Guide for Dividend Investing Outside Canada.

We’ll start with US dividend stocks or dividend-focused exchange traded funds that you plan to hold for the long term in order to generate investment income. The first thing you need to know is that you’ll have to do without the dividend tax credit that makes dividends from Canadian companies so attractive when received in taxable accounts.

Imagine you’re a senior with an annual income of $40,000. Your marginal tax rate on eligible dividends (these are paid by most publicly traded corporations) would range from zero to 11.7%, depending on the province where you live. US dividends are treated like regular income, which means the marginal tax rate for this same individual would range from about 23% to about 32.5%.

TFSAs sound like an obvious solution here. You can invest up to $5,000 a year in a TFSA and pay zero in taxes on any type of investment gain. TFSAs are not perfect for US dividend stocks, however.

The reason is that the US Internal Revenue Service will apply a withholding tax to your dividend payments that can’t be recovered. TD Waterhouse advises that the withholding tax rate for a TFSA is 30%, but you can have it reduced to 15% by filling out a W-8BEN form. Your investment dealer should be able to provide you with one of these forms.

Now for RRSPs and registered retirement income funds, which are second-best places to put Canadian dividend stocks because you lose out on the dividend tax credit. Put US dividends in a registered account and the dividend tax credit is a non-issue. Also, you’re shielded from the withholding tax when your US dividends flow into a registered retirement account.

“There’s a specific exception under the Canada-US tax treaty that says there’s no withholding tax in [registered retirement] accounts,” said Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management. “So the full amount of the dividend comes into the RRSP or RRIF and can compound there on a tax deferred basis.”

One alternative is to hold those US dividend stocks in a non-registered account, where you can claim a credit for the 15% withholding tax when filling out your annual income tax return.

Mr. Golombek said the amount of withholding tax you paid will be listed in a T-slip sent by your investment firm or adviser. In filing your tax return, include a T2209 foreign tax credit form (found online at http://bit.ly/fvCiad).

The long-term view on the right vehicle for your US dividend stocks is a little more complicated. It all comes down to taxes. In a TFSA, you’ll pay the 15% withholding tax on your dividends and then the taxman is off your back permanently. In a registered retirement account, you avoid the withholding tax but expose yourself to income tax on the dividends when you withdraw them as retirement income.

Let’s say $100 worth of dividends are paid by US stocks held in your TFSA and you reinvest the net $85 amount (remember the withholding tax) in such a way that it compounds at 5% annually for 20 years. You’ll end up with $225, which compares to $172 if you received $100 in a registered account (no withholding tax), let it compound for 20 years at 5% annually and then paid tax on it at a rate of 35% in retirement.

The registered account would be more attractive if you were in a lower tax bracket in retirement. It’s also worth noting that, unlike with TFSAs, you get a tax refund when making RRSP contributions. If you reinvest this money back into your plan, you have a very competitive investing alternative to the TFSA.

The TFSA regains its appeal if you’re buying US stocks for capital gains and regard dividends as incidental. “Capital gains are most tax advantageous in a TFSA because they’re completely tax free,” Mr. Golombek said.

His pick as a second-best choice: The non-registered account, where you pay tax only on 50% of your capital gains. A less appealing option for capital gains-focused investing: registered retirement accounts.

Mr. Golombek’s reasoning applies not only to US stocks, but to any stocks or ETFs you’re investing in for capital gains. In a registered account, the full amount of your capital gains will be taxed at your usual rate when you withdraw the money in retirement. You’ll have forgone an opportunity to pay zero in taxes in the TFSA, or to pay taxes on only half your gains in the non-registered account.

Global stocks are available to Canadian investors directly through many investment dealers, and some can be bought as American depositary receipts listed on the big US exchanges. ADRs are shares of foreign companies that trade in US dollars. They’re considered foreign stocks for Canadian investors and thus can be subject to withholding taxes of 15 to 30% in accounts of all types.

You may be willing to live with having your global dividends clipped by withholding taxes in a TFSA. But in a registered retirement plan, you’ll have both withholding taxes and income taxes when you make a withdrawal. The non-registered account is halfway between the two – you’ll pay tax on them at your regular rate, but, as with US investments, you can claim credit for the withholding tax.

A Tax Guide to Dividend Investing

Jamie Golombek of CIBC Private Wealth Management has prepared this table showing how much you're left with on an ultimate after-tax basis when you receive $100 in dividends in various types of accounts:

chart
Click to Enlarge

Assumptions

- Ontario 2011 top tax bracket taxpayer/marginal tax rate of 46.41%
- Funds in RRSP/RRIF/TFSA immediately withdrawn

Note 1 - Ignores deduction previously granted for RRSP contribution
Note 2 - dividend tax credit applies, assumes eligible dividends
Note 3 - assumes 15% non-resident withholding tax is eligible for foreign tax credit in non-registered accounts
Note 4 - assumes tax treaty between Canada and foreign jurisdiction reduces rate to 15%, no exemption for retirement plans

Source: Jamie Golombek, CIBC Private Wealth Management

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