Canada already provides retirees with two important sources of retirement income through the Canada Pension Plan (CPP) and Old Age Security (OAS). Both can provide valuable lifetime income, but I would not rely on them alone to fund the retirement lifestyle I want.
Housing, groceries, transportation, travel, and healthcare expenses can quickly consume those monthly payments. OAS can also be subject to the recovery tax, commonly called the OAS clawback, once your taxable income becomes sufficiently high.
Workplace pensions can help fill the gap, but not everyone has one. Even among those who do, defined benefit pension plans that provide predictable lifetime payments have become harder to come by.
Fortunately, investors can build another source of recurring cash flow themselves. One of the simplest approaches is accumulating dividend-paying stocks throughout your working years and eventually using those dividends to supplement retirement income.
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Why the TFSA works so well in retirement
The Tax-Free Savings Account (TFSA) is particularly useful for building this personal income stream. Investments held inside the account can compound tax free, and qualified withdrawals are also completely tax free. That means you can spend dividends received inside your TFSA without adding them to your taxable income.
That becomes particularly useful during retirement. Registered Retirement Income Fund (RRIF) withdrawals generally count as taxable income. TFSA withdrawals do not, which means they also do not contribute toward the income used to determine the OAS clawback.
There are also no mandatory TFSA withdrawals. You can take out exactly what you need and leave the remainder invested, and amounts withdrawn are generally restored as contribution room the following calendar year.
Building your own monthly income stream
You could assemble a portfolio of individual dividend stocks, but I would rather diversify. One option is iShares S&P/TSX Composite High Dividend Index ETF (TSX: XEI).
XEI provides exposure to a diversified portfolio of 75 Canadian dividend-paying companies across sectors including financials, energy, utilities, pipelines, and telecommunications. Instead of depending on one company’s dividend to fund your retirement, you’re spreading that income across numerous businesses.
The ETF currently offers a 3.41% trailing 12-month distribution yield and pays monthly, which can be convenient for retirees accustomed to budgeting around regular cash flow. XEI also charges a relatively modest 0.22% management expense ratio (MER).
Of course, this isn’t literally a pension. XEI’s distributions are not guaranteed, its share price can fall, and there is no promise of lifetime payments. But accumulated over decades inside a TFSA, a diversified dividend ETF can provide another recurring source of cash flow alongside CPP, OAS, and any workplace retirement benefits.
