How to Build a Balanced TFSA Focused on Income and Capital Gains

This strategy can deliver decent returns while also reducing risk for investors.

Canadian investors are using their self-directed Tax-Free Savings Account (TFSA) to create investment portfolios that can deliver tax-free passive income and boost personal wealth.

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TFSA 101

The government launched the TFSA in 2009 to give Canadians another vehicle in addition to the Registered Retirement Savings Plan (RRSP) to build savings for retirement or to meet other financial goals. Since inception, the cumulative maximum TFSA contribution room has increased to $109,000 per person for anyone who has qualified every year.

Capital gains, dividends, and interest income earned inside a TFSA are tax-free and can be removed as tax-free income at any time. Any withdrawals made from a TFSA automatically open up equivalent new contribution room in the following calendar year, in addition to the regular TFSA limit increase.

Retirees can use the TFSA to generate tax-free income that won’t put their Old Age Security (OAS) pensions at risk of a clawback. Younger investors might decide to maximize TFSA contributions and bank RRSP space for later years when they will likely have higher salaries. RRSP contributions reduce taxable income, so the tax savings are larger when a person is in a higher marginal tax bracket.

GICs or dividend stocks

Rates offered on Guaranteed Investment Certificates (GICs) have increased in recent weeks in step with a jump in bond yields. Non-cashable GICs offer the best rates. Normally, the longer the term, the higher the rate that is offered, but that isn’t always the case.

At the time of writing, investors can get non-cashable GIC rates above 3.30% for one-year GICs and more than 4% for five-year certificates, depending on the issuer. These rates are comfortably above the current rate of inflation in Canada, which came in at 2.8% in June. As long as the GIC is within the $100,000 threshold and is from a Canada Deposit Insurance Corporation (CDIC) member, the funds are safe.

It is important to plan cash needs before locking up big chunks of savings in multi-year GICs. Investors should ensure they have access to funds for emergencies. In addition, a surge in inflation could quickly drive rates much higher, as occurred in 2022 and 2023, so there is a risk of missing out on potential higher rates.

Dividend stocks are another popular TFSA investment for both retirees and younger savers. Dividend yields are often higher than GIC rates and steady dividend growth raises the return on the initial investment. Companies that boost their dividends annually tend to see their share prices move higher over the long run. Stocks also provide good liquidity, as they can be sold at any time to access the funds.

On the downside, there is a risk of capital loss. Share prices can fall below the purchase price. Sometimes they take years to recover, or never return to previous levels. Dividends are not 100% safe, although top dividend-growth stocks are unlikely to reduce their distributions.

Enbridge (TSX: ENB), for example, has increased its dividend annually for more than 30 years and the stock currently offers a 5% dividend yield.

The company continues to grow through acquisitions and has a secured capital program of $40 billion in development projects. This should enable steady dividend increases in the coming years. Long-term holders of Enbridge’s shares have enjoyed attractive total returns.

The bottom line

The right mix of GICs and dividend stocks is different for each investor depending on the person’s age, risk tolerance, required returns, and need for quick access to the invested funds.

In the current market conditions, investors can quite easily build a diversified TFSA portfolio with GICs and dividend-growth stocks to get an average yield of at least 4%. This provides a return above inflation while also reducing portfolio risk.

The Motley Fool recommends Enbridge. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker has no position in any stock mentioned.

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