Tax-free savings accounts (TFSA) provide various benefits for retirement planning, including tax protection and flexibility. These two attributes make them ideal for investors seeking to maximize returns from fixed-income returns.
Unlike RRIFs and RRSPS, a TFSA offers a tax shield for both income paid into the account — interest and dividends, for example — and withdrawals from the account, according to the Globe and Mail
. And unlike RRIF and RRSP accounts, TFSAs are not exposed to clawbacks of Old Age Security benefits.
But there are some caveats to using TFSAs. Dividends from US stocks held in TFSAs are subject to a 15% non-resident withholding tax. The accounts have set contribution limits, so they typically can’t hold enough money to meet an investor’s retirement-income needs on their own. A TFSA that’s too focused on dividends and bond interest will also likely be sensitive to rising interest rates.
“Yes, you might be able to pull off a certain yield,” said Neville Joanes, CFA, who oversees portfolio management at robo-advisor firm WealthBar. “But the value of the investments is going to decrease significantly.”
According to Joanes, equity ETFs typically produce returns similar to dividend ETFs and can have markedly lower costs in certain cases. But he conceded that dividend ETFs’ monthly distributions — compared to quarterly or semi-annual distributions for equity ETFs — may be preferable for investors who need cash income.
The retirement-income TFSA recipe Joanes recommended included four or five ETFs that cover bonds, global stocks, and REITS; high-yield bonds and preferred shares can also be included. He suggested that investors use short-term bond ETFs with both government and corporate debt. For exposure outside Canada, he suggested that investors use funds without currency hedging, as he’s found non-hedged funds to be less volatile compared to their hedged counterparts.
According to Nancy Woods, an investment advisor at RBC Dominion Securities
, it’s possible to get average returns of 5% to 7% from a TFSA built for retirement income, with 2% to 3% from dividends and the rest derived from growth.
Compared to taxable accounts, TFSAs also have an edge because they can also wipe out the responsibility of tracking tax obligations — a particular concern for REITs. According to Mark Goodfield, a partner at accounting firm BDO Canada, REITs may produce capital gains, which are subject to a 50% inclusion rate; various forms of income that can be taxed as regular income; and a return of capital, which isn’t taxed in the year it’s received, but instead lowers the cost base for an investment.
Goodfield said that REIT distributions have to be documented in T3 slips yearly, and the investors have to supply their 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,” he said.
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