Canadians are looking for ways to get better returns on their savings without taking on too much risk. Investors seeking higher passive income also want to avoid getting pushed into a higher marginal tax bracket, while seniors who receive Old Age Security (OAS) need to watch out for the OAS clawback.
Fortunately, the Tax-Free Savings Account (TFSA) is a tool that can be used to achieve these goals.
TFSA facts
The TFSA came into existence in 2009 as a new vehicle to help Canadians meet their financial goals. Each year, a TFSA contribution limit is set, enabling people to make investments inside the TFSA to earn tax-free interest, dividends, or capital gains.
The TFSA limit in 2023 is $6,500. This brings the cumulative maximum contribution room to $88,000 for anyone who has qualified since inception. Unused contribution room can be carried forward to future years. The government indexes the size of the TFSA limit to inflation with increases set at $500 increments. In 2024, the TFSA limit will be at least $6,500.
All earnings on investments held inside the TFSA are tax-free and can go right into your pocket. Any money removed from the TFSA during the year opens up equivalent new contribution space in the following calendar year. This is in addition to the regular annual TFSA limit.
Investors have to make sure they don’t take money out and then put it back into the TFSA in the same calendar year if they have already reached their maximum contribution level. Going over the TFSA limit triggers a 1% per month tax penalty on the amount that is above the limit.
OAS clawback
TFSA earnings won’t count towards the CRA’s net world income calculation used to determine the OAS pension recovery tax, also known as the OAS clawback. This is why retirees should consider using their full TFSA contribution space to hold income-generating investments before putting money into taxable accounts.
Most sources of retirement income are taxable. They can add up quickly if a person receives a decent company pension along with government pensions and other income from savings and investments. As soon as net world income tops a minimum threshold, the CRA implements a 15% OAS recovery tax on the income above that level. The threshold in the 2023 income year is $86,912.
Investments for TFSA passive income
Current market conditions are favourable for savers. Soaring interest rates have driven up the rates that financial institutions will offer on guaranteed investment certificates (GICs). Rates above 5% are common for terms of four or five years, while one-year and two-year GICs from several issuers are above 5.5%.
Dividend stocks have taken a beating over the past year due to the rise in interest rates. This highlights the risks associated with owning stocks, but the pullback in many high-quality dividend payers has now pushed up yields to very attractive levels and there is an opportunity to generate good capital gains if the stocks rebound, which is likely to occur as soon as interest rates start to fall.
TC Energy (TSX:TRP) and Telus (TSX:T), for example, have increased their dividends annually for more than two decades and now offer yields of 8% and 6.6%, respectively, at the time of writing.
The bottom line on TFSA passive income
Investors can easily put together a diversified portfolio of GICs and high-yield dividend stocks that would provide an average yield of at least 6% today. On a TFSA of $60,000, this would generate $3,600 per year in tax-free passive income. That’s an average of $300 per month!
