Canadian investors are using their self-directed Tax-Free Savings Account (TFSA) to set up portfolios of investments to provide tax-free passive income that can complement CPP, OAS, and company pensions in retirement.
In the current market conditions in which the TSX is near its record high and economic headwinds might be on the horizon, it makes sense to take a defensive and balanced approach to building an income fund.
TFSA basics
Canada created the TFSA in 2009 to give investors an extra vehicle to save for future goals. This could be for a major purchase, like a house, or to build a retirement fund. People who are self-employed or prefer contract work often don’t have company pensions, so their retirement planning is their own responsibility.
Anyone who has qualified to make TFSA contributions since 2009 now has up to $102,000 in cumulative TFSA contribution space. The TFSA limit in 2026 will be $7,000, bringing the total maximum contribution room to $107,000 per person.
Unused TFSA contribution space carries forward. In addition, any funds removed from a TFSA during the year will open up equivalent new contribution room in the following calendar year.
All interest, dividends, and capital gains earned inside a TFSA are tax-free. They can be fully reinvested or removed as tax-free income that won’t bump you into a higher tax bracket or put Old Age Security payments at risk of an OAS clawback.
GICs or dividend stocks
A Guaranteed Investment Certificate (GIC) pays a fixed amount of interest for a set time. As long as the GIC is issued by a Canada Deposit Insurance Corporation (CDIC) member and is within the $100,000 limit, the full amount of the investment is insured by the government in the event the financial institution goes bust.
Non-cashable GIC rates of 3% to 3.5% are available right now depending on the term and the issuer. This is above the current 2.2% inflation rate in Canada, so it makes sense to hold some GICS in an income portfolio. The downside of a non-cashable GIC is that the money is locked up for the term. Cashable GICs are available, but they pay lower interest rates.
Dividend stocks can provide higher yields than GICs and the rate of return can grow each time the dividend payment is increased. Stocks can also be sold to access the funds quickly, so they provide more liquidity. That being said, stocks also carry capital risk. The share price can fall below the price paid for the stock and dividends are not 100% safe. Investors can, however, find TSX dividend stocks with long track records of delivering steady distribution growth.
Enbridge (TSX:ENB), for example, has raised its dividend in each of the past 30 years. The company grows earnings through acquisitions and development projects to support dividend increases. Investors who buy ENB stock at the current level can get a dividend yield of 5.6%.
The bottom line
The TFSA is a helpful tool for Canadians who want to set up their own income fund. The right mix between GICs and dividend stocks depends on risk appetite, desired returns, and the need to access the capital. In the current market conditions, it is quite easy to put together a diversified portfolio of GICs and dividend stocks to generate an average yield of 4%.
