Canadian couples are realizing that they can generate significant tax-free income by taking advantage of the contribution space available in their Tax-Free Savings Accounts (TFSAs).
TFSA limit
The TFSA limit in 2023 is $6,500. This brings the cumulative maximum TFSA contribution space to $88,000 for a person who has qualified since the government launched the TFSA in 2009. A couple would have as much as $176,000 right now in TFSA room to build a portfolio of investments to generate passive income that won’t bump them into higher marginal tax brackets.
For seniors, this is even more important, since the earnings from the TFSA do not get counted toward net world income that is used by the Canada Revenue Agency to determine the Old Age Security (OAS) pension recovery tax, also referred to as the OAS clawback.
Dividend stocks or GICs for a TFSA income fund?
In recent years, there was little reason for savers to buy Guaranteed Investment Certificates (GICs) for portfolios focused on passive income due to the horrible rates. The situation has changed dramatically in the past 12 months as a result of the Bank of Canada’s aggressive series of interest rate increases designed to get inflation under control.
As interest rates rise, the rates investors can get from lending money to banks and other financial institutions tend to follow the upward trend. Investors can currently get a GIC that pays as high as 5.5% for 12-month term and above 5% for GICs of up to five years, all from Canada Deposit Insurance Corporation members. That means the GIC is insured by the government even if the provider goes bust, as long as the investment is within the $100,000 limit.
Inflation came in at 3.3% in July in Canada, so 5% is an attractive risk-free rate of return on savings. The downside of a GIC is the relatively short timeframe to get the rate and the fact that the investor does not have access to the principal during the term of the GIC.
Canadian dividend stocks filled the gap for investors seeking yield over much of the past decade. Stocks come with risks, as we have witnessed in the past three years, but dividends were really the only game in town for decent yields.
The jump in interest rates in the past year contributed to the latest pullback in the share prices of many top TSX dividend payers. Part of this is due to investors shifting funds to GICs. The other side of the story is that higher interest rates drive up borrowing costs. This makes debt more expensive for businesses that borrow funds to finance projects. Higher debt costs can reduce cash available for distributions.
At this point, however, the drop in the share prices of many great dividend-growth stocks is probably overdone. Enbridge (TSX:ENB) is a good example. The stock is down considerably even though the outlook remains positive for revenues and cash flow. Enbridge has increased its dividend for 28 consecutive years, so the distribution should be safe.
Interest rate hikes are likely near their peak, and GIC rates might have already topped out. Once the Bank of Canada signals it is done raising interest rates, GIC rates will probably drop, and the share prices of reliable dividend stocks should recover.
At this point, it probably makes sense to hold some GICs to reduce portfolio risk while taking advantage of the dip in top dividend stocks to benefit from higher yields.
The bottom line on TFSA passive income
TFSA investors can easily get an average return of 6% right now from a mix of GICs and quality dividend stocks. On a single TFSA portfolio of $88,000, this would generate $5,280 per year that doesn’t bump the investor into a higher marginal tax bracket and won’t put OAS pension payments at risk of a clawback.
That means a couple could generate $10,560 in annual tax-free passive income!
