Canadian savers are using their Tax-Free Savings Account (TFSA) to build portfolios of investments that can generate reliable streams of tax-free passive income to help cover rising living costs and complement company pensions, Canada Pension Plan (CPP), and Old Age Security (OAS) pensions.
TFSA 101
The TFSA limit is $6,500 in 2023. That brings the cumulative total contribution space to a maximum of $88,000 for anyone who has qualified since the launch of the TFSA in 2009. The TFSA limit in 2024 will be at least $6,500.
As the name implies, profits earned inside a TFSA and removed as income are tax-free. In addition, the total amount of TFSA withdrawals in a year automatically opens up equivalent contribution space in the following calendar year on top of the regular TFSA limit increase.
This gives people the flexibility to pull money out as needed and to put funds back into the TFSA later to earn more tax-free passive income.
Retired couples have a combined contribution room of $176,000. This is ample space to build meaningful income funds that won’t push them into a higher marginal tax bracket. TFSA earnings are not taxed, and they do not count towards net world income that is used by the Canada Revenue Agency to determine the OAS clawback.
Income from personal pensions, CPP, OAS, and Registered Retirement Income Fund (RRIF) payments all get bundled together to calculate net world income, and it doesn’t take long for these amounts to add up to the minimum income threshold for the OAS pension recovery tax. In the 2023 income year, the individual trigger point for the 15% OAS clawback is $86,912 in net world income.
Best investments for a TFSA?
Retirees have to balance the return they want with the amount of risk they are willing to take on with the TFSA investments. Guaranteed Investment Certificates (GICs) currently pay decent rates in the 5-5.5% range today. These are risk-free investments as long as the GIC provider is a Canada Deposit Insurance Corporation member and the amount is less than the $100,000 limit.
GICs offer the interest payments monthly, semi-annually, annually, or compounded. Rates vary depending on the payout frequency, but investors have a variety of options. The downside of the GIC is that the principal is locked for the term of the certificate, so the funds are generally not accessible in the event of a financial emergency.
Dividend-growth stocks come with risk. The share price can fall below the purchase price, and dividends sometimes get reduced when a business runs into difficulties. On the positive side, many top dividend stocks raise their distributions annually, so the yield on the original investment increases. Stocks can be sold quickly to access the invested funds, providing more flexibility.
The steep rise in interest rates over the past year that has driven up GIC rates has also triggered a market correction in dividend stocks. The pullback appears overdone in many cases, and some yields are above GIC rates.
A combination of GICs and quality high-yield, dividend-growth stocks is probably the way to go for most TFSA investors today.
Good examples of top dividend-growth stocks with yields of 6% to 7.5% right now include Telus, BCE, TC Energy, Enbridge, Bank of Nova Scotia, and CIBC, among others.
The bottom line on TFSA passive income
TFSA investors can easily put together a diversified portfolio of GICs and high-yield dividend stocks to get an average return of 6.15% today. On a TFSA of $88,000, this would generate $5,412 per year in tax-free passive income for an individual. Couples could get $10,824.
That works out to an average of $902 per month in tax-free earnings that won’t put OAS pensions at risk of a clawback!
