Penalty for holding dividend stocks in a TFSA?

Q: I hold blue-chip stocks that pay a dividend in my TFSAs. I have been told by a friend that I will be penalized for this. What does he mean?

— Morgan

A: “Penalized” is a strong word, but there are some tax issues to be aware of when you hold dividend stocks in a TFSA.

Let’s start with one of the most common misunderstandings: that holding Canadian stocks in a TFSA (or an RRSP) means you’re forfeiting the dividend tax credit. Canadian dividends are taxed favourably: an Ontario investor who earns $50,000 would pay just $64 in taxes on an additional $1,000 in Canadian dividends after accounting for the tax credit. That same $1,000 in interest income would come with a tax bill of almost $300. That’s why, if your TFSA and RRSP are both maxed out, it often does make sense to hold Canadian stocks in a non-registered account and use the TFSA and RRSP for assets that are taxed less favourably.

However, if you have plenty of room in your TFSA, there’s nothing wrong with holding Canadian blue chips there. It’s true you won’t be able to claim the dividend tax credit, but that’s because you’re paying zero tax on the dividends already. Holding your stocks in the TFSA also means all the capital gains will be tax-free.

If your blue chip stocks are U.S. dividend payers, there’s another tax issue to understand: the U.S. imposes a 15% withholding tax on dividends paid to Canadians. However, if you hold your U.S. stocks in an RRSP, this withholding tax does not apply. And if you hold them in a non-registered account, you can recover it by claiming the foreign tax credit on your return. Unfortunately, you can’t avoid the withholding tax in a TFSA.

With that in mind, it might be better to hold U.S. blue chips inside your RRSP rather than your TFSA. But again, you need to consider the big picture. If your registered accounts are not maxed out, it is certainly better to hold U.S. dividend payers in a TFSA than in a non-registered account. Yes, you will lose the withholding tax, but the remaining dividends and all of the capital gains will be tax-free forever.

—Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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