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investor clinic

A few years ago I started accounts worth $5,000 for each of two grandchildren, and invested all of the money in BCE preferred shares (BCE.PR.K). The value of these accounts has since fallen to about $3,900, but my adviser recommends we leave them as is. The funds will not be needed for the grandchildren until about 15 years from now. I have thought about dumping the shares but feel the capital loss at this point would be significant, and perhaps the shares will pick up in the years to come?

As I discussed in two recent columns - here and here - rate-reset preferred shares such as BCE.PR.K were hammered by the recent drop in bond yields. Although I'm not privy to your adviser's thinking, my guess is that he or she was looking for a relatively low-risk option for you that would provide some protection if interest rates rose. But to the surprise and disappointment of many people who bought these complex securities, interest rates fell instead, contributing to a hefty drop in the shares.

Now that rate-reset preferreds have fallen significantly, some fund managers believe they are attractive at current levels. But it's really anyone's guess as to whether they will rebound and by how much. It will depend on the future direction of interest rates, the spreads on new issues and other factors.

With respect to BCE.PR.K specifically, the yield will reset in late 2016 at a spread of 1.88 percentage points above the Government of Canada five-year bond yield. (For reset purposes, the preferred share's yield is calculated as the annual dividend expressed as a percentage of the share's par value of $25, not its market value).

The fact that you have suffered a paper loss is unfortunate but it shouldn't play into your decision to hold or sell the shares. That's water under the bridge; all that matters now is the expected future return. If you believe that a different investment will provide a higher potential return, it might be worth selling BCE.PR.K and buying something else. However, you should also consider the transaction costs, particularly if you are working with a full-service adviser who charges a commission on trades.

Two other factors to consider are the time horizon and diversification. If the money will not be needed for 15 years, you might wish to consider investing in something that provides more growth potential (preferred shares are usually purchased for income, not growth). Investing the entire account in a single stock is probably not a good idea, however, because it entails too much risk; a low-cost index exchange-traded fund or mutual fund – particularly one that allows full reinvestment of dividends to maximize compounding – will give you both growth potential and diversification. Another option is a balanced fund that offers equity and fixed-income exposure. These are things you can discuss with your adviser in the context of what is best for your grandchildren.

Is one allowed to purchase U.S. securities in a tax-free savings account (TFSA) and how are the subsequent dividends treated? Would they constitute a contribution to the plan?Yes, you're allowed to purchase U.S. securities in your TFSA. No, the dividends – whether they're from U.S., Canadian or any other stocks – do not count as contributions to your TFSA. Receiving dividends will have no impact on your contribution room.

There is something you should be aware of, however: If you hold U.S. stocks in your TFSA, the dividends will be subject to 15-per-cent U.S. withholding tax. Furthermore, you cannot claim this amount as a foreign tax credit, as you could if the U.S. stock were held in a non-registered account.

The good news is that you can avoid taxes on U.S. dividends altogether by holding your U.S. stocks in your registered retirement savings plan (RRSP). Under the Canada-U.S. tax treaty, RRSPs and other accounts for retirement or pension purposes – such as locked-in retirement accounts (LIRAs) and registered retirement income funds (RRIFs) – are exempt from withholding tax.

TFSAs are not strictly retirement accounts and are therefore subject to U.S. withholding tax. The same goes for registered education savings plans (RESPs).

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