In an important article published recently in The Globe and Mail (July 14, 2017) financial journalist Rob Carrick observed: ‘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.’
Is he on to something?
‘I think the idea is great, in general,’ said Neville Joanes, quoted in the same article. He oversees portfolio management at the robo-advisory firm WealthBar and holds the chartered financial analyst (CFA) designation. He adds this 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.’
The versatility of TFSAs
TFSAs were always designed to be versatile. People use them to hold savings, or investments, 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 carefully as they deserve by seniors as a retirement vehicle.
Said Nancy Woods, an investment adviser with RBC Dominion Securities: ‘When people ask me what to do first, I say that I think the TFSA is more important than the RRSP. The best two tax-sheltered vehicles – your home and your TFSA.’
Let’s examine this idea further.
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paid into your account in the form of dividends, bond interest and more is sheltered from tax, and so is all money withdrawn from the account.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.
As Mr. Carrick states: ‘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.’
Total returns of 5% to 7% possible in a TFSA designed for retirement income
Ms. Woods believes total returns of 5% to 7% 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.’ WealthBar 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 Mr. Joanes prefers conventional equity funds. Dividend ETFs are less volatile, but equity funds produce similar returns and have markedly lower costs in some cases.
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% inclusion rate. In both cases, the tax hit is lighter than it would be for regular income.
A small tax flaw
A small tax flaw in the TFSA is that dividends paid by U.S. stocks are subject to a 15% 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.’
While using a TFSA could be an excellent strategy for retirees to use as a device for generating retirement income, it pays to consult and investment advisor and tax professional before going ahead.
Geoff Funke, Senior Wealth Advisor, Scotia Wealth Management, 604-535-4721.