Passive Income: How to Reduce Risk and Still Earn High Yields in a TFSA

Investors can use this strategy to get good returns on TFSA investments.

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Retirees and other self-directed Tax-Free Savings Account (TFSA) investors seeking passive income want to get the best return possible from their savings without taking on too much risk.

TFSA rules

Canada created the TFSA in 2009 as a new tool to help people meet their financial goals. The TFSA limit is $6,500 in 2023, bringing the cumulative maximum contribution space to $88,000 since inception. New TFSA room opens up each year. The TFSA limit will be at least $6,500 in 2024. Increases to the limit are in $500 increments and are indexed to inflation. Unused contribution space carries forward indefinitely.

All interest, dividends, and capital gains earned inside a TFSA from Canadian sources are not taxed and can be removed as tax-free income. People don’t have to worry about being bumped into a higher marginal tax bracket, and seniors avoid triggering the Old Age Security (OAS) pension recovery tax.

This is a big deal if you are holding investments in taxable accounts instead of using your available TFSA space.

Any amount withdrawn from the TFSA will open up equivalent new contribution room in the following calendar year in addition to the regular TFSA limit increase.

Best TFSA investments for passive income

Income investors have largely relied on dividend stocks to generate income in recent years due to the terrible rates paid on fixed-income products. In the past 12 months, however, the steep increase in interest rates by Bank of Canada has given investors more options to generate decent returns while reducing the portfolio risk that comes with being overweight on stocks.

Guaranteed Investment Certificates (GICs) from Canada Deposit Insurance Corporation members currently offer rates as high as 5.5% depending on the term and the payout frequency of the interest. With inflation now down to about 3%, this is an attractive risk-free option, as long as the GIC is insured.

Investors with low-risk tolerance might be inclined to go 100% into GICs, but there are a few things to consider. The principal investment is locked up for the term of the GIC, so you don’t have access to the funds. In addition, there is no guarantee GIC rates will be the same or better when the GIC matures. You might have to renew the investment at a lower rate, which would reduce income. As inflation falls back to the 2% target range, the Bank of Canada could reduce interest rates in the next few years, especially if the economy goes into a recession.

Dividend stocks took a beating in the past year as higher interest rates made fixed-income alternatives more attractive. At this point, many top TSX dividend stocks appear oversold and offer dividend yields that are above GIC rates.

Stock prices can fall below the purchase price, and dividends sometimes get cut, so you have to keep this in mind when adding stocks to the portfolio. That being said, it makes sense for most TFSA investors seeking passive income to have a mix of stocks and GICs today.

Leading dividend stocks raise their distribution at a steady pace. This increases the yield on the initial investment. Stocks with regular dividend growth also tend to see their share prices move higher over the long term. Finally, stocks can be sold to access funds in an emergency.

At the time of writing, some great Canadian dividend stocks look cheap and offer attractive yields. BCE (TSX:BCE), for example, trades near $56.50 compared to more than $70 at the peak in 2022.

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Investors who buy t the current level can get a yield of 6.9%. The board has increased the dividend by at least 5% in each of the past 15 years.

The bottom line on TFSA passive income

Investors seeking passive income can use a mix of GICs and top dividend-growth stock to build diversified high-yield TFSA portfolios today that have a lower risk profile than an all-stock fund. The right combination of GICs and stocks depends on the return required, the need to access the investments, and the person’s risk tolerance.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker owns shares of BCE.

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