Canadians are searching for ways to get better returns on their savings without being bumped into a higher tax bracket. One popular strategy involves taking advantage of the Tax-Free Savings Account (TFSA) to own investments that generate passive income.
TFSA limit
The TFSA contribution limit is $6,500 for 2023. This brings the maximum contribution space per person to $88,000 since the launch of the TFSA in 2009. Each year, the government gives TFSA investors more room. The size of the TFSA limit increases in step with inflation but by increments of $500. The 2024 TFSA limit will be at least $6,500.
Interest, dividends, and capital gains generated inside the TFSA are tax-free. In addition, earnings removed from the TFSA do not get counted as income and are not taxable. As a result, the full amount of the passive income generated from the TFSA investments can go straight into your pocket.
Seniors who receive Old Age Security (OAS) don’t have to worry about TFSA income causing a clawback on their OAS pension.
Any money removed from the TFSA during the year automatically opens up equivalent new contribution room in the next calendar year in addition to the regular TFSA limit.
Are GICs or dividend stocks better for passive income?
Investors can finally get decent rates on Guaranteed Investment Certificates (GICs) issued by members of the Canada Deposit Insurance Corporation (CDIC). This is the result of the big spike in interest rates over the past 18 months.
At the time of writing, GICs with terms of one year to five years offer rates in the 5.5% to 5% range, respectively. As soon as the Bank of Canada signals it is done raising interest rates the financial institutions will likely lower the rates offered on GICs, so there might be a limited window of opportunity for GIC investors to lock in rates at these levels. Economists have mixed opinions on when rate cuts will occur, with some expecting the first reduction as early as the first quarter of 2024.
GICs are attractive for investors who want zero risk on the invested funds and do not need access to the invested money during the duration of the GIC term.
Another option is to buy top TSX dividend stocks. The market correction in some segments over the past year hit dividend stocks quite hard. Many now appear oversold and offer dividend yields above top GIC rates. Stock prices can be volatile, and dividends sometimes get cut, but good dividend-growth stocks typically raise the payout annually and normally bounce back from pullbacks.
Enbridge currently appears oversold and offers a dividend yield of 7.8%. The board raised the dividend in each of the past 28 years. BCE is another top dividend-growth stock to consider for passive income. The communications giant increased the dividend by at least 5% in each of the past 15 years. At the time of writing BCE stock offers a 7% yield.
As dividends increase, the yield on the initial investment rises. Stocks can be sold at any time to access the capital in an emergency. In addition, there is a chance of generating capital gains if the share price moves above the purchase price.
Investors have to weigh the risks and rewards of GICs and stocks to decide how to allocate their funds.
The bottom line on TFSA passive income
In the current market conditions, investors can quite easily put together a diversified portfolio of GICs and top dividend stocks to get an average yield of 6%. This would generate $3,000 per year in tax-free passive income on a $50,000 TFSA and won’t push the investor into a higher tax bracket or put OAS at risk of a clawback.
