In an earlier blog/video, we compared four different ETFs for capturing the U.S. total stock market. These included:
We now need to include some caveats to the conversation in the form of tax ramifications. The U.S. government levies a 15% tax on U.S. dividends paid to Canadian investors. And because these taxes are sometimes withheld before you receive your cash dividends, you may never notice they’re there. But they are. And their impact can be far greater than a fund’s more obvious MER or expense ratio.
The amount of foreign withholding taxes you end up paying depends on two important factors. The first is the structure of the ETF that holds the stocks. The second is the account type used to hold the ETF.
In terms of fund structure, VTI and ITOT are U.S.-listed ETFs, holding U.S. stocks. In contrast, VUN and XUU are Canadian-listed ETFs that hold U.S.-listed ETFs that hold U.S. stocks.
In terms of account types, we’ve got various registered and non-registered accounts, which will also determine the level of withholding taxes applied to your U.S. stock dividends.
Foreign Withholding Taxes in RRSPs
First, let’s look at your RRSP, or similar registered accounts such as a RRIF, LIRA or LIF. For these, the winning choice from a withholding tax perspective is a U.S.-listed ETF that holds U.S. stocks, like VTI or ITOT. That’s because holding a U.S.-listed U.S. equity ETF in your RRSP exempts all dividends from the 15% U.S. withholding tax, due to a tax treaty between Canada and the U.S.
In comparison, the 15% withholding tax will apply if you hold a Canadian-listed ETF that holds a U.S.-listed ETF that holds U.S. stocks … like VUN or XUU. Since January 1st, 2014, the annualized return drag for VUN from foreign withholding taxes has been noticeably more than its management expense ratio.
Foreign Withholding Taxes in TFSAs
And what if you’re holding U.S. equity ETFs in a TFSA, RESP, or RDSP? Unfortunately, there’s nothing you can do about the withholding tax drag within these account types. U.S.-listed U.S. equity ETFs (like VTI or ITOT) receive no preferential tax treatment here, so they’re effectively the same as Canadian-listed ETFs that hold U.S.-listed U.S. equity ETFs (like VUN or XUU) and are subject to a similar foreign withholding tax drag.
For this reason, I would recommend opting for VUN or XUU in your TFSA, RESP, and RDSP accounts. You don’t get the tax break no matter what, but these fund structures help you avoid costly currency conversion fees (which we’ll discuss in our next blog/video), as well as a host of other issues.
Foreign Withholding Taxes in Non-Registered Accounts
Now onto your non-registered accounts. U.S. withholding tax also applies here, no matter which ETF structure you choose.
At tax time, you can generally claim a foreign tax credit to recover the foreign taxes paid, but you will still pay Canadian income tax on the full dividend.
Since the foreign withholding tax implications are the same for both structures in your non-registered accounts, I would generally recommend sticking with Canadian-listed ETFs that hold U.S.-listed U.S. equity ETFs, like VUN and XUU.
In our next blog/video, we’ll show you why you may still want to avoid investing in VTI or ITOT, even in accounts where the foreign withholding taxes are eliminated. See you soon!