How to Use Your TFSA to Create $5,000 in Tax-Free Passive Income

Creating passive income doesn’t have to be risky, and there’s one ETF that could create substantial income over time.

Amy Legate-Wolfe

Author Bio

Amy became interested in investing in 2018 after having her first daughter. After receiving a masters degree in journalism from Western University, she became frustrated that the finance industry remained a confusing place for Canadians like her: new parents, millennials, and other young people who needed to understand their finances. Now, Amy focuses on tech companies and renewable energy for growth opportunities, coupling that with long-term investing strategies and equities. She also provides investors with a daily newsletter, Canada Stock Digest, for daily market updates. Her work can also be found at Canada's National Observer, where she writes on the business side of climate action. Before joining Motley Fool Canada, Amy wrote for major news organizations including HuffPost, CTVNews.ca, and CBC. When she’s not researching investing strategies, Amy’s time is pretty much monopolized by her two wild daughters, but in what little spare time she has she loves to do yoga, go on walks with her dog, and travel with her husband.

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“October: This is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” – Mark Twain

Published November 15, 2024 9:00 pm EST

Using a Tax-Free Savings Account (TFSA) to earn $5,000 in tax-free income each year is a powerful way for Canadians to grow their wealth. For investors aiming to achieve this income goal, a well-chosen dividend exchange-traded fund (ETF) can be an effective solution. And today, we’re going to look at one stand-out option.

ETF stands for Exchange Traded Fund — Source: Getty Images

Setting it up

The beauty of the TFSA lies in its tax-free advantage. Any income or capital gains generated within the account aren’t subject to taxes, meaning that Canadians can keep every dollar they earn inside it. With a cumulative contribution room of up to $95,000 as of 2024 for those eligible since the TFSA’s introduction, there’s ample room to grow investments.

iShares S&P/TSX Composite High Dividend Index ETF (TSX: XEI) is a strong TFSA option. XEI is designed to replicate the performance of the S&P/TSX Composite High Dividend Index, emphasizing companies with established dividend histories. This ETF comprises leading Canadian businesses across sectors that are well-known for delivering high dividends. With these companies in its portfolio, XEI provides investors with the peace of mind that comes from holding shares in established dividend payers.

Strong performer

Beyond its appealing yield, XEI has delivered a strong performance, with a year-to-date return of 17% and a one-year return of 24.8%. Such performance showcases its potential for growth while generating income. The ETF’s top holdings represent a blend of defensive and growth-oriented sectors, including energy, financial services, utilities, and communication services. This diversification helps spread risk while capturing income from multiple areas of the economy, adding resilience to the portfolio.

XEI’s sector breakdown is worth noting. It has substantial exposure to energy and financial services, followed by utilities and communication services. These sectors are traditionally strong in dividend payments, which supports XEI’s high yield. Energy and financial services are especially important to Canada’s economy. And the ETF’s high allocation to these sectors makes it well-suited for investors who want to benefit from Canada’s strongest industries.

Low fees, high payments

One notable advantage of XEI is its low management expense ratio (MER) of 0.22%, which is competitive for a high-yielding dividend ETF. Keeping fees low is crucial because high fees can erode returns over time. Especially for dividend investors who rely on compounding returns. XEI’s low fee structure ensures that investors retain a higher percentage of their returns, thus maximizing the long-term value of their investments.

Moreover, XEI pays dividends monthly, making it an attractive choice for investors who prefer consistent cash flow. For anyone looking to supplement their income or cover monthly expenses with passive income, XEI’s monthly distributions provide both predictability and regularity.

Bottom line

So how much would investors need to create that $5,000 each year in passive income through dividends? Let’s take a look based on XEI’s performance and dividend income.

COMPANY	RECENT PRICE	NUMBER OF SHARES	DIVIDEND	TOTAL PAYOUT	FREQUENCY	INVESTMENT
XEI	$27.89	3,546	$1.41	$4,999.86	monthly	$98,897.94

Now you have $4,999.86 in dividend income, but through a massive $98,897.94 investment. And of course, no investment is without risks. XEI’s heavy exposure to the energy sector means it can be more volatile when energy prices fluctuate. Dividend payments, while consistent in recent history, aren’t guaranteed and depend on the financial health of the companies within the ETF. However, XEI’s diversified structure offers some stability by balancing the energy sector with other industries.

In conclusion, investing in XEI within a TFSA is a compelling way to generate $5,000 in tax-free income. With its strong yield, robust performance, low fees, and monthly dividends, XEI stands out as a suitable option for Canadian investors looking for passive income. While it’s always wise to consider personal financial goals and risk tolerance, XEI offers a balanced approach to generating income, capturing Canadian economic strengths and taking advantage of the tax-free growth benefits of a TFSA.