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DIY investors, please stop stressing about holding U.S. ETFs paying dividends in a tax-free savings account.

A 15-per-cent U.S. withholding tax is applied to dividends paid into TFSAs by U.S. companies and ETFs. In registered retirement savings plans, this tax does not apply. In non-registered accounts, you may be able to claim a foreign tax credit for the amount paid in withholding tax. Is avoiding U.S. content in TFSAs the right approach?

A surprising high percentage of the questions I get from readers ask this very question in one form or another. Sample: “We are a little confused about how to hold Canadian-based U.S. equity ETFs in our TSFA accounts without incurring U.S. taxes,” one reader recently wrote. “Are there particular ETFs or strategies we should focus on?”

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It’s worth noting that the withholding tax on dividends isn’t that significant a hit unless you have a large account. It’s not a glaring blunder to be dinged by the withholding tax in your TFSA if your U.S. holdings are part of a strong-performing, well-diversified portfolio. But all of that said, there is an ETF that lets you invest in the U.S. market and deke around the withholding tax.

The Horizons S&P 500 Index ETF (HXS-T) pays no dividends. Instead, its unit price reflects the total return for the S&P 500 – a blend of changes in the price of shares in the index with the dividends they pay. If the index rose 5 per cent for a year and dividends provided another 2 per cent, HXS shares would ideally rise by 7 per cent minus fees. The shares of a regular U.S. equity ETF would rise by 5 per cent, and you would receive dividends yielding 2 per cent. No dividends from HXS mean no withholding tax.

A complication with HXS is that it doesn’t hold the actual S&P 500 stocks. Instead, it uses financial instruments called derivatives to replicate the index total return. This complexity adds a small extra level of risk, but Horizons says it has taken a variety of steps to protect unit holders.

The management expense ratio for HXS is 0.11 per cent, and the trading expense ratio (that’s the cost of trading securities for the fund) comes in at 0.3 per cent. If you consult the Globe and Mail ETF Buyer’s Guide, you’ll see that U.S. equity ETFs listed on the Toronto Stock Exchange have MERs as low as 0.08 per cent and TERs as low as zero. But HXS does something others cannot. It lets you invest in the U.S. market without the cost or stress of withholding taxes.

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