When Canadians compare the Tax-Free Savings Account (TFSA) with the Registered Retirement Savings Plan (RRSP), the discussion usually comes down to tax savings.
RRSP contributions can reduce your taxable income today, making the deduction particularly valuable during higher-earning years. TFSA contributions provide no deduction because they’re made with after-tax dollars.
Your current tax bracket and expected tax bracket in retirement should therefore play a major role in deciding which account to prioritize. But I think there’s another question worth asking: what are you actually trying to accomplish with the money?
If one of your objectives is building an investment portfolio that eventually produces passive income you can spend, I think the TFSA has some significant advantages.
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Why I prefer the TFSA for passive income
The biggest advantage is straightforward: qualified TFSA withdrawals are tax-free. Suppose your investments eventually generate $1,000 per month. You can withdraw that $12,000 annually from your TFSA without adding it to your taxable income.
An RRSP works differently. Withdrawals are generally taxable as ordinary income, and financial institutions usually withhold some tax when you take money out. Unlike TFSA withdrawals, RRSP withdrawals also don’t restore your contribution room.
The distinction becomes even more important once an RRSP is eventually converted into a Registered Retirement Income Fund (RRIF). RRIF withdrawals count toward taxable income, and minimum withdrawals eventually become mandatory.
That additional taxable income can interact with income-tested government benefits, including the Old Age Security (OAS) recovery tax. The TFSA has none of those complications, giving it far more flexibility.
Become a landlord in your TFSA
Real estate is one of the oldest passive-income strategies around, but I have little interest in dealing with the work that comes with owning a rental property. Tenants, mortgages, property taxes, insurance, vacancies, maintenance, and unexpected repairs can quickly make “passive” income rather active.
A real estate investment trust (REIT) exchange-traded fund (ETF) offers another approach. One option is BMO Equal Weight REITs Index ETF (TSX: ZRE). ZRE owns a diversified portfolio of Canadian REITs spanning property types such as residential, retail, industrial, office, and healthcare.
The equal-weight methodology is particularly useful in this sector. Instead of allowing the largest REITs to dominate the portfolio according to market capitalization, ZRE spreads its exposure more evenly across its holdings and periodically rebalances them.
You effectively get exposure to rent collected across a large portfolio of properties without personally finding tenants, fixing appliances, arranging mortgages, or managing buildings.
ZRE currently offers a 4.49% annualized distribution yield and charges a 0.61% management expense ratio. Those distributions can then accumulate inside a TFSA without Canadian tax, and you can withdraw the cash when you need it.
REITs still carry plenty of risk. Property values can fall, vacancies can rise, borrowing costs matter, and distributions can be reduced. But for investors who want real estate income without becoming landlords themselves, I think an ETF like ZRE is a much simpler approach.
