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How to turn your TFSA into a tax-free income-making machine in retirement

TFSAs are still new enough that using them for generating tax-free retirement income is a fresh concept.

Just fill your tax-free savings account with dividend stocks, real estate investment trusts, preferred shares and such, and then pay yourself tax-free income using the combined income and share price appreciation. For simplicity and efficiency, it's a breakthrough strategy.

"I think the idea is great, in general," said Neville Joanes, who oversees portfolio management at the robo-advisory firm WealthBar and holds the chartered financial analyst (CFA) designation. His proviso: Because they have only been around since 2009 and yearly contribution room is limited, TFSAs won't typically have enough money in them to meet an individual's entire retirement-income needs. Registered retirement plans and non-registered investments will also play a role.

TFSAs were designed to be versatile, and so they are. People use them to hold savings, or investing to generate both growth and dividends. But with registered retirement savings plans and registered retirement income funds so well entrenched, TFSAs may not be considered as much as they should be for use by seniors as a retirement vehicle.

"When people ask me what to do first, I say that I think the TFSA is more important than the RRSP," said Nancy Woods, an investment adviser with RBC Dominion Securities. "The best two tax-sheltered vehicles – your home and your TFSA."

The retirement-income TFSA offers two levels of tax freedom. Income paid into your account in the form of dividends, bond interest and more is sheltered from tax, and so is all money withdrawn from the account. None of RRSPs, RRIFs or non-registered accounts can deliver both of these benefits together.

Tax-free withdrawals address a commonly heard complaint from seniors about how money taken out of a RRIF and RRSP is treated as regular income and taxed accordingly. RRIF and RRSP income can also push you into the zone where some or all of your Old Age Security benefits are clawed back. TFSA income has no impact on your benefits from OAS or the Guaranteed Income Supplement.

Both Mr. Joanes and Ms. Woods believe in using a total-return approach with a TFSA being used for retirement income. That means drawing on conventional investment income such as interest and dividends while also selling a bit of your holdings here and there. Your initial capital is left untouched – what you're tapping into is the growth in the value of your holdings over time.

Ms. Woods believes total returns of 5 per cent to 7 per cent are possible on average in a TFSA designed for retirement income. Dividends might hypothetically account for two to three percentage points of that amount, while growth delivers the rest.

Tempted to build a TFSA that produces enough of a yield in dividends and bond interest to meet your income needs? Mr. Joanes warns that you could end up with a portfolio that is highly vulnerable to rising interest rates. "Yes, you might be able to pull off a certain yield," he said. "But the value of the investments is going to decrease significantly."

Mr. Joaness' firm uses exchange-traded funds, or ETFs, to build portfolios. It's natural to think about using dividend stocks or ETFs for a retirement-income TFSA, but he prefers conventional equity funds. Dividend ETFs are less volatile, but equity funds produce similar returns and have markedly lower costs in some cases.

He does see one argument for dividend ETFs: The monthly distributions they pay (equity ETFs typically pay quarterly or semi-annually) may satisfy much of your need for cash income and reduce the need to sell investments. Each buy and sell transaction will typically cost close to $10 at an online broker, although some offer commission-free ETF trading.

To keep a retirement-income TFSA easy to manage, Mr. Joanes suggests using four or five ETFs covering bonds, global stocks and maybe real estate investment trusts, or REITs, as well. High-yield bonds and preferred shares are other possible choices.

For bonds, he suggests using a short-term bond ETF containing both government and corporate bonds. For U.S. and international exposure, he suggests using funds without currency hedging where there is a choice available between hedged and non-hedged. He finds that non-hedged versions of the indexes that many ETFs track are less volatile than those with hedging.

The tax advantage of using TFSAs for retirement income over RRIFs is not quite as dramatic when you compare TFSAs with taxable accounts. You pay zero tax on a TFSA withdrawal, while money paid from a RRIF is taxed as regular income. With a non-registered account, dividends get the benefit of the dividend tax credit and capital gains are taxed at a 50-per-cent inclusion rate. In both cases, the tax hit is lighter than it would be for regular income.

Where TFSAs look amazing in comparison with taxable accounts is in relieving you of the responsibility to track how much tax you owe. Let's use REITs as an example. Mark Goodfield, a partner at accounting firm BDO Canada, said these securities may produce a mix of capital gains, which are subject to a 50-per-cent inclusion rate for tax purposes; various types of income that are treated as regular income; and, a return of capital, which isn't taxed in the year you receive it. Instead, a return of capital lowers your cost base for an investment. This in turn means a larger capital gain when you sell, or a reduced capital loss.

REIT distributions are documented in T3 slips on a year-by-year basis. But when it comes time to sell, it's up to you to supply your adjusted cost base. "I would say there's a significant number of people who would not be aware of this or, if they are aware of it, they would take a guess or ignore it," Mr. Goodfield said.

A small tax flaw in the TFSA is that dividends paid by U.S. stocks are subject to a 15-per-cent non-resident withholding tax. You avoid this tax in RRSPs and can claim a foreign tax credit in a taxable account, but the money is lost in a TFSA.

Ms. Woods said U.S. stocks should first and foremost go in RRSPs. But she believes that losing a bit of your dividend in order to have a strong total-return stock in your TFSA portfolio is a fair trade-off.

U.S. dividends are also useful as a source of cash for Canadians who spend time in the United States, she said. "A lot of snowbirds I have [as clients] want accessible U.S. money in their TFSA."

Introducing the retirement-income TFSA

The tax-free savings account is ideal for use by retirees to produce investment income. Here are two approaches to building a retirement-income TFSA, one emphasizing simplicity for do-it-yourselfers and the other a more sophisticated approach. Both portfolios were put together by Neville Joanes, who oversees portfolios for the robo-adviser WealthBar. Exchange-traded funds are used in each case.

The Simple DIY Portfolio

ETFStock symbolMER (%)Yield (%)**Weighting (%)
iShares Short Term High Quality Canadian Bond Index ETFXSQ-T0.14*1.560
iShares Core S&P 500 Index ETFXUS-T0.11.620
Vanguard FTSE Developed All Cap ex U.S. Index ETFVDU-T0.212.315
BMO Equal Weight REITs Index ETFZRE-T0.615.35

Key points: Low cost of ownership and trading. Well diversified. Easy to maintain. VDU covers off Canada; moving five percentage points of this weighting to a Canadian market ETF is an alternative.

The WealthBar Conservative ETF Portfolio

ETF Stock symbol MER (%) Yield (%)** Weighting (%)
Vanguard Canadian Short-Term Corporate Bond Index ETF VSC-T 0.11 1.6 25
Vanguard Canadian Short-Term Bond Index ETF VSB-T 0.11 1.0 15
BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF ZWA-T 0.72 4.6 15
BMO High Yield US Corporate Bond Hedged to CAD Index ETF ZHY-T 0.62 5.6 10
BMO Laddered Preferred Share Index ETF ZPR-T 0.5 4.3 10
iShares Core S&P 500 Index ETF XUS-T 0.1 1.6 7.5
iShares Core MSCI EAFE IMI Index ETF XEF-T 0.22 4.7 7.5
Horizons S&P/TSX 60 Index ETF HXT-T 0.03 n/a*** 5
BMO Equal Weight REITs Index ETF ZRE-T 0.61 5.3 5

Source: Rob Carrick; Neville Joanes

*estimated / **yields for equity ETFs are based on recent distributions to shareholders; bond ETF yields are calculated as the portfolio yield if all bonds are held to maturity, minus fees / ***HXT pays no cash dividend; instead, fund units reflect total returns of share price change and dividends

Key points: Adds exposure to areas such as high-yield bonds, preferred shares and covered-call options. The WealthBar team monitors global markets and adjusts this portfolio as required

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