The Saga Continues – What To Hold And What NOT To Hold In A TFSA Or ISA

Purpose and summary

This post is motivated by another incredibly frustrating discussion I had with someone this morning. The problem is aggravated by the reliance on a financial planner selecting the composition of a TFSA portfolio aggravated by what (in my opinion) is unnecessary churning of the account.

While it is important that U.S. citizens in Canada DO have TFSAs, it is important that they keep track of the income earned in the TFSA. It is also important that they do NOT invest in mutual funds or ETFs inside the TFSA or ISA*. People should invest in individual stocks which pay dividends. I will now explain why.

The reality of the middle class investor and the Canadian TFSA

1. Canadian TFSAs are essentially “brokerage accounts” with a special tax designation which means that the income (whether interest, dividends and capital gains) is NOT taxed in Canada. At present (although the Canada/U.S. tax treaty clearly allows this to be changed) the income inside the TFSA is taxable to U.S. citizens who file a U.S. tax return. Many people assume that because the income is not taxable in Canada, it is not taxable in the United States.
2. Because the income is not taxable in Canada many people who hold TFSAs do NOT receive annual statements or tax information reporting slips. This makes it very difficult to determine how much income was earned inside the TFSA. This is a HUGE problem for many U.S. citizens who wish to report this income on their U.S. tax returns. It is a particular problem (this is where I see it most) when people wish to renounce and wish to meet the five year tax compliance prior to renunciation.
3. To the extent that the TFSA holds non-U.S. mutual funds or other pooled funds, a majority of tax preparers regard these as PFICs. PFICs carry very punitive tax consequences and very punitive reporting requirements (Form 8621).
4. When doing a Streamlined filing (the “Relief Procedures For Former Citizens“) have different rules, certifying five years of compliance requires tremendous work in understanding and organizing the transactions. Trust me! You will be charged a lot of money to figure this out (if it even can be determined). Bottom line: Do not invest in non-U.S. mutual funds inside your TFSA (the same principle applies to the UK ISA).
5. To keep it simple your TFSA should hold individual shares of stocks. These can be U.S. stocks or non-U.S. stocks. The result of this will be that the income earned inside the TFSA can be easily identified and reported on a U.S. tax return. Dividends (and capital gains) are generally subject to preferential taxation under U.S. rules. The result is that you may not owe any U.S. tax at all. In addition, by holding individual shares, the sale of the shares will be processed as capital gains (either short of long term) and taxed accordingly. In addition, please be aware that stocks held for one year or more, when sold will qualify as “long term” capital gains which are taxed less aggressively than “short term gains”. All of this is the difference between your TFSA working for you and likely NOT creating U.S. tax problems and the process becoming a total nightmare.
6. I don’t want to overgeneralize on what I am about to say. But, … financial planners often recommend non-U.S. mutual funds and many have a propensity to “churn” those funds. I see this time and time again in the world of assisting people with U.S. citizenship renunciation. Mutual funds and “churning” are  in the interests of the financial planner and NOT in your interest.

In life and in TFSAs:

“Simplicity Is Virtue!!”

John Richardson

*Appendix A – An interesting development for those with U.K. ISAs

As I understand, the UK will begin imposing a tax on excess cash held as part of an ISA portfolio. See the discussion here. This clearly has a number of “moving parts” and is critical for U.S. citizens living in the U.K.

Appendix B – Additional recent posts discussing various aspects of the TFSA

Tracking Income In Your TFSA, ISA Or Other Account That Is Not Taxable In Your Country Of Residence

Help Needed: Time For The Canadian TFSA To Be Treated As A Pension Under The Canada U.S. Tax Treaty