Written by Andrew Walker at The Motley Fool Canada
Canadian seniors are looking for ways to get more income to offset higher living costs without being pushed into a higher tax bracket or getting hit with the Old Age Security (OAS) pension recovery tax. One popular strategy to achieve this goal involves taking advantage of a Tax-Free Savings Account (TFSA) contribution room to hold investments that generate passive income.
TFSA limit increase
The government created the TFSA in 2009 to give Canadian residents a new tool to help them meet their financial goals. Since its inception, TFSA contribution room has grown to its current maximum level of $88,000 per person. The 2023 TFSA limit is $6,500. Next year, it will be at least that amount, giving investors even more room to generate tax-free passive income. The size of the TFSA limit each year is indexed to inflation and is increased by $500 increments.
Money removed from the TFSA in a given year opens up equivalent new contribution space in the following calendar year. This is in addition to the regular TFSA limit. Interest, dividends, and capital gains generated inside the TFSA and removed are all tax-free. This means the full amount of the income earned in a TFSA can go right into your pocket without worrying about the need to share it with the Canada Revenue Agency (CRA).
Seniors who receive OAS pensions need to watch their income level. When net world income gets too high, the CRA implements its OAS pension recovery tax, otherwise known as the OAS clawback. Each dollar of net world income above a minimum threshold triggers a 15-cent reduction in the OAS payment in the following year. The threshold for the 2023 income year is $86,912.
For example, a senior who has net world income of $106,912 in 2023 would see their OAS reduced by $3,000 for the payment period of July 2024 to June 2025. That’s a big hit, so it makes sense to try to shift as much investment income as possible from taxable accounts to a TFSA.
Best TFSA investments for passive income
Retirees currently have a window of opportunity to get decent rates on Guaranteed Investment Certificates (GICs). The rates offered by Canada Deposit Insurance Corporation (CDIC) members are above 5% right now for multi-year GICs. This might not last for much longer. As soon as the Bank of Canada indicates it intends to reduce interest rates, the financial institutions will reduce the rates paid on GICs.
At the same time, investors should consider top TSX dividend stocks that currently appear oversold and offer dividend yields that are above the best GIC rates. Stocks like Enbridge, BCE, and Bank of Nova Scotia offer yields of 7.8%, 7%, and 6.7%, respectively, at the time of writing.
As soon as interest rates start to come down again, there will likely be a rally in dividend stocks. Buying at the current levels locks in the current yield on the initial investment if the dividend simply remains at the existing payout. Each time the dividend increases, the yield on the investment goes up. This is not the case with GICs, where the rate paid is fixed for the term of the certificate.
Stock prices can fall below the purchase price, so owning shares comes with risks. GICs are risk-free as long as the GIC is from a CDIC member and is below the $100,000 limit. Good dividend-growth stocks, however, tend to rebound from pullbacks. The increase in the share price gives investors a chance to book capital gains if they decide to sell.
Stocks also offer more flexibility. The shares can be sold at any time to access the invested money. GIC investments that offer the best rates are non-cashable, so investors have to wait until the end of the term of the GIC to get their invested capital.
The right mix is different for every investor and depends on risk tolerance, need for access to the capital, and desired rate of return.
The bottom line on using the TFSA to avoid the OAS clawback
Seniors can easily put together a diversified portfolio of GICs and top dividend stocks to get an average yield of 6.25% in the current market conditions. On a TFSA of $88,000, this would generate $5,500 per year in tax-free passive income that won’t put OAS at risk of a clawback.
The post How to Use a TFSA to Boost Income and Avoid the OAS Clawback appeared first on The Motley Fool Canada.
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The Motley Fool recommends Bank Of Nova Scotia and Enbridge. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker owns shares of BCE and Enbridge.