Canadian savers are using their self-directed Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP) to create portfolios of investments that can provide passive income to complement government and work pensions.
Many people think it will take a long time, or require too much savings, to build a portfolio that is large enough to generate enough cash to make a difference in their lives, but that might not be the case.
Source: Getty Images
Power of compounding
One popular strategy for building a self-directed pension fund involves owning top dividend-growth stocks and using the distributions to buy additional shares. This sets off a powerful compounding process that can turn modest initial investments into significant savings over the course of 20 or 30 years, especially when dividends increase at a steady pace and the share price trends higher.
Fortis (TSX: FTS) is a good example of a leading Canadian dividend stock with a long track record of dividend growth and capital appreciation.
The company has increased its dividend for 52 consecutive years and intends to boost the distribution by 4% to 6% annually through at least 2030.
Profit growth is expected to come from new assets being built under the current $28.8 billion capital program. As the projects are completed and go into service, the increase in cash flow should support the planned dividend increases. Fortis gets most of its revenue from rate-regulated utility businesses. This means cash flow tends to be predictable and reliable. Households and companies need to use electricity and natural gas, regardless of the state of the economy.
Long-term investors have done well holding Fortis in their portfolios. A $10,000 investment in FTS stock 30 years ago would be worth about $300,000 today with the dividends reinvested. At the current dividend yield of 3.3%, this would generate nearly $10,000 per year in dividend income.
TFSA or RRSP?
The TFSA limit is $7,000 in 2026. That brings the cumulative maximum contribution space to $109,000 for anyone who has qualified to make TFSA contributions since the inception of the program in 2009.
Younger investors might decide to make TFSA contributions first and save RRSP space for later when they will likely be in a higher marginal tax bracket and can benefit more from the reduction in taxable income that RRSP contributions provide. TFSA contributions offer more flexibility, as the funds can be easily removed at any time to cover emergency expenses. Any withdrawal from a TFSA during the year opens up equivalent new TFSA space in the following calendar year. If you think you might need to access savings quickly, the TFSA might be the better place to start investing.
RRSP contribution space is determined by employment income. Under the current rules, people can contribute 18% of their previous year’s reported earned income in their RRSP, up to a limit. The RRSP contribution room amount is shown on the annual notice of assessment that is provided by the CRA.
As mentioned, RRSP contributions can be used to reduce taxable income in the relevant year. This primarily benefits people in the highest marginal tax brackets. Ideally, the goal is to contribute at a higher tax rate and remove the funds in retirement when annual income is lower. RRSP withdrawals are treated as taxable income.
The bottom line
The amount of time required to create a meaningful dividend fund depends on the amount a person can spare for savings each year and the size of the income stream that is required. As the Fortis example shows, however, the amount of upfront money needed might be a lot lower than many people would expect.
