Pensioners are searching for ways to get better returns on their savings without being bumped into a higher tax bracket or being hit with a clawback on their Old Age Security (OAS) payments. One way to achieve this goal is to generate passive income inside a Tax-Free Savings Account (TFSA).
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TFSA advantage
The soaring cost of living in Canada is making life difficult for retirees. Government pensions like the Canada Pension Plan (CPP) and Old Age Security (OAS) are indexed to inflation, but the increases might not be keeping up with the real-life jump in monthly expenses. In addition, this money is taxable.
The TFSA was created in 2009 to give Canadians a new savings tool to help meet financial goals. Each year, people who qualify are allowed to contribute an amount to their TFSA. The TFSA limit is $6,500 in 2023. This brings the cumulative maximum contribution room to $88,000 per person. As such, a retired couple would have as much as $176,000 in combined TFSA contribution space. That’s enough to generate meaningful tax-free passive income on investments.
OAS pension recovery tax
Retirees who receive OAS should consider maxing out their TFSA contribution space before holding income-generating investments in taxable accounts. Interest, dividends, and capital gains generated inside the TFSA are all tax-free and can be removed as income without the amount being counted toward the net world income calculation the Canada Revenue Agency uses to determine the OAS pension recovery tax.
In the 2023 income year, the number to watch is $86,912. Every dollar of income above this threshold triggers a 15-cent reduction in the OAS that will be paid in the July 2024 to June 2025 payment period. This means a person with net world income of $106,912 in 2023 would see their OAS reduced by $3,000 next year.
That is a big hit that should be avoided, if possible.
TFSA investments for passive income
Retirees have an opportunity today to get good rates on Guaranteed Investment Certificates (GICs) and high-quality dividend stocks. The right mix depends on the person’s need for access to the invested funds, the amount of return desired, and the tolerance for risk.
GICs pay a fixed rate for the term of the investment. The capital is safe as long as the GIC is issued by a Canada Deposit Insurance Corporation (CDIC) member institution and the amount is within the $100,000 limit. Funds invested in non-cashable GICs, however, are not available until the GIC matures. In addition, the rate that will be available when it is time to renew the GIC could be much lower if interest rates decline in the next few years. At the time of writing, investors can get GICs paying more than 5.5% for terms of one to three years.
Dividend stocks carry risks. The share price can fall below the purchase price, and dividends can get cut if a company gets into financial trouble. On the positive side, many top-quality dividend stocks increase their distribution per share every year, and many now offer yields that are above GIC rates. In addition, stocks can be sold to get access to the invested money in the event there is a need to access the funds.
Enbridge (TSX:ENB), for example, has increased its dividend annually for the past 28 years. The stock price is down to the point where investors can now get a dividend yield of 8%.
Fortis (TSX:FTS) has raised its dividend annually for the past 50 years and intends to boost the distribution by 4% to 6% per year through at least 2028. At the time of writing, Fortis stock provides a 4.25% yield. This is below the best GIC rates today, but the dividend growth over the coming years will narrow the gap. Each time a company raises its dividend, the yield on the initial investment increases.
The bottom line on TFSA passive income
Retirees can easily put together diversified portfolios containing GICs and high-quality dividend stocks to get an average yield today of at least 6.25%. For a couple with combined TFSA portfolios of $176,000, this would generate $11,000 per year in tax-free passive income that won’t put OAS at risk of a clawback.
