Canadian investors can take advantage of their annual Tax-Free Savings Account (TFSA) contribution limit to build a self-directed portfolio of income-generating investments.
One popular TFSA strategy involves holding a combination of Guaranteed Investment Certificates (GICs) and Canadian dividend stocks. With the cumulative maximum TFSA contribution limit now at $109,000, investors can generate meaningful tax-free income on their portfolios.
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GIC pros and cons
A sell-off in bonds in recent weeks has led to a rise in bond yields. This, in turn, is driving up the rates offered on GICs by the Canadian banks and other GIC providers.
GICs purchased from Canada Deposit Insurance Corporation (CDIC) members, and within the $100,000 limit, provide investors with a no-risk option to generate income on savings. Rates offered on GICs depend on the term of the GIC and frequency of the interest payout. Non-cashable GICs with annual or compound interest payments normally provide the best rates. At the time of writing, investors can get GICs with interest rates in the 3% to 4% range, depending on the issuer and the term. Inflation in Canada is near 2%, so investors who are simply searching for a no-risk option to get a return on their savings that keeps up with inflation should be comfortable owning GICs in this environment.
The downside of a GIC is that the rate of return is fixed for the duration of the certificate. Rates that are available for reinvestment when the GIC matures might be lower, so there is no guarantee the income stream will be maintained. In addition, funds held in a non-cashable GIC are locked up until the GIC matures. This is important to consider when determining how much liquidity a person needs to maintain in their TFSA holdings.
Dividend stock pros and cons
Dividend stocks have a lot of attractive features for income investors. The distributions often provide a higher yield than the rates offered on GICs, and many top TSX dividend payers have long track records of delivering annual dividend increases. Each dividend hike raises the yield on the initial investment, so the return can grow steadily for years. In addition, shares can be sold at any time to access the invested capital for an emergency, or a planned withdrawal to cover the cost of a vacation or a large purchase. Share prices in leading dividend-growth stocks tend to rise over the long run, providing capital gains to complement the income.
In the short term, however, share prices can fall below the purchase price. Market corrections, segment weakness, or company-specific issues are all part of the risks that come with owning shares. When a company runs into financial challenges, the dividend can be reduced or even eliminated. This can put added pressure on the share price.
With the TSX currently trading near its record highs and economic uncertainty on the horizon, it makes sense right now to consider dividend stocks that will likely continue to boost their distributions even if there is a downturn.
Enbridge (TSX: ENB), for example, has increased its dividend in each of the past 30 years and has a $39 billion capital program on the go to drive growth over the medium term.
The stock has enjoyed a nice rally over the past two years, but investors can still get a 5% yield at the current share price.
The bottom line
Investors have to consider their risk tolerance, required return, and need for liquidity when determining the best mix of GICs and dividend stocks. In the current market environment, it is quite easy to put together a diversified portfolio of GICs and TSX dividend stocks to get an average return of 4.3%. On a TFSA of $109,000, this would generate annual tax-free income of $4,632.50. That works out to just over $386 per month.
