USD TFSA Explained: Rules, Benefits and Risks

It’s perfectly fine to have more than one tax-free savings account (TFSA). Many investors keep a TFSA for cash savings with an online bank and a separate TFSA for investments held at a discount broker or portfolio manager. However, having multiple TFSAs — especially when one holds U.S. dollars — increases the risk of accidentally overcontributing. There’s a 1% per month penalty tax on excess TFSA contributions, so it’s important to understand how contributions are calculated and reported.

What investments qualify inside a TFSA

The Canada Revenue Agency sets out which investments can be held in a TFSA. The permitted categories are similar to those allowed in a registered retirement savings plan (RRSP). Common qualifying investments include:

• cash
• mutual funds
• securities listed on a designated stock exchange
• guaranteed investment certificates (GICs)
• bonds
• eligible shares of small business corporations

That broadly covers stocks, exchange-traded funds (ETFs), real estate investment trusts (REITs) and other publicly traded securities. U.S. stocks and ETFs that trade on U.S. exchanges are allowed in a TFSA so long as your account permits foreign securities. Some TFSA products, though, are limited to cash and GICs or to a narrow list of proprietary mutual funds, so check what your specific TFSA accepts before attempting to buy U.S. securities.

Buying U.S. exposure without U.S. dollars

If you prefer not to hold U.S. dollars directly, Canadian depositary receipts (CDRs) are an alternative. CDRs represent fractional ownership of foreign-listed companies and trade in Canadian dollars on Canadian exchanges. Because they’re denominated in Canadian dollars, CDRs avoid the need to convert currency or maintain a U.S.-dollar account.

One trade-off is that many CDRs are currency hedged, which reduces the benefit of diversification from holding U.S. dollars. That makes them a convenient option for avoiding FX conversions but limits currency exposure benefits.

How TFSA contribution amounts are calculated

When you contribute Canadian dollars to a TFSA, the contribution amount is straightforward. When you contribute foreign currency — for example, U.S. dollars — your financial institution converts that amount to Canadian dollars for reporting to the Canada Revenue Agency. The converted Canadian-dollar amount is what counts against your TFSA contribution room.

Because conversion rates fluctuate and institutions may use different rates, many people prefer to contribute in Canadian dollars or to allow a safety buffer when converting U.S. dollars. Financial institutions can apply a rate that differs from published mid-market FX quotes by one to a few percent. To reduce the chance of an overcontribution, consider leaving a buffer when contributing foreign currency — for example, around 5% — then ask your institution afterward what Canadian-dollar amount it reported to the CRA. If you find you’ve undercontributed, you can always top up in Canadian dollars.

Remember that your financial institution reports contributions and withdrawals to the CRA but is not responsible for tracking your available TFSA room. It’s ultimately your responsibility to ensure you do not exceed your contribution limit.

Also note that withdrawals from one TFSA do not immediately create contribution room in another TFSA. Withdrawals create additional TFSA room starting the following January 1. If you withdraw from a TFSA and then recontribute the withdrawn amount in the same calendar year, you risk an overcontribution and the associated monthly penalty.

Foreign withholding tax on TFSA holdings

If you hold U.S. securities or other foreign investments inside a TFSA, foreign withholding tax generally applies to dividends and certain distributions. For example, U.S. withholding tax will be deducted at source from dividends paid on U.S. shares held in a TFSA. Your financial institution typically handles withholding before funds are deposited to your account.

Withholding tax is a final tax obligation to the foreign tax authority in most cases, which means a Canadian resident who is not a U.S. citizen usually has no further foreign tax filing required for those amounts.

Final thoughts

Including U.S. and other foreign stocks in a diversified portfolio can complement Canadian holdings. Using a TFSA that accepts U.S. securities is a valid strategy for gaining U.S. equity exposure. If you prefer to avoid currency conversion, consider alternatives such as Canadian-listed U.S.-equity ETFs or CDRs, but be aware of differences in hedging and currency exposure.

If you plan to contribute U.S. dollars directly to a TFSA, double-check how your institution converts those funds to Canadian dollars and how that converted amount will affect your available TFSA room. Using a modest buffer and confirming the reported Canadian-dollar contribution after the transaction can help minimize the risk of accidental overcontribution.

Read more from Jason Heath:

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• How the Liberals’ re-election impacts RRIFs, taxes and more
• Should you set up a corporation with friends to invest?
• How to avoid RRSP overcontributions when you have a deferred profit sharing plan