Need income? Use your TFSA

According to the unofficial numbers I’ve seen, more than 3.5 million Canadians opened Tax-Free Savings Accounts (TFSAs) in 2009. Based on the questions and comments I’ve received, many of them ended up in the wrong type of account.

It has been suggested that the inclusion of the word “savings” in the name of this new type of investment is part of the problem. Some people have incorrectly assumed that meant the only option for a TFSA was some type of bank savings account. With interest rates at record lows, the result was a near-zero return in the first year of the new program. Unfortunately, switching these low-yielding accounts to a more flexible self-directed plan will cost more in many cases than the interest generated over the past 12 months.

The key to a productive TFSA is to have a clear goal in mind before you set it up. Knowing what purpose you want your TFSA to serve will determine the most appropriate investments. Then find the least expensive plan that enables you to buy the securities you want.

Until now, few people have looked at TFSAs as a source of tax-free income. But now that we’re about to move into the second year of the program, this is an option to consider. As of January 1, 2010, each Canadian 18 or over will have another $5,000 in contribution room. If you did not take advantage of the plan in 2009, the carry-forward will give you a total of $10,000 next year or $20,000 for a couple.

It’s not a fortune but the tax-free income that amount of money can generate is significant and will continue to grow annually. The question is how best to invest the money?

In order to maximize the benefits of a TFSA, I advise avoiding securities that generate tax-advantaged income. That would include preferred shares, dividend-paying common stocks, REITs, and mutual funds that are structured to pay tax-efficient distributions.

The best tax bang for your TFSA buck will come from bonds, GICs, and other interest-bearing securities. That’s because interest income is taxed at your top marginal rate. Using a TFSA to shelter that income means the government won’t get a penny of it.

In “normal” times, it’s easy to generate at a return of at least 5 per cent from low-risk interest-bearing securities such as GICs. That would represent $1,000 in tax-free income in 2010 for a couple who makes the maximum investment. But these times are anything but normal. According to, the highest rate being offered on a five-year GIC right now is 3.8 per cent. The major banks are paying much less, about 2 per cent. No one should be locking in their money for five years for that kind of pittance.

What’s the alternative? My old favourite: corporate bonds. There is somewhat more risk than with GICs but you have to accept that for the higher returns. And if you choose your bonds carefully, the risk is minimal.

In mid-December I did a search and found several high-quality corporate issues maturing in the next 4-6 years that were quoted with yields of 5.75 per cent or higher. One example was a Bank of Nova Scotia bond maturing on May 12, 2014. It has an A+ credit rating and was priced at par to yield 5.75 per cent to maturity. For those willing to go out farther and take a little more risk, a RONA Inc. issue maturing October 20, 2016 was quoted with a 6.07 per cent yield. It has a credit rating of BBB-.

These are not formal recommendations but simply illustrations of the opportunities available in mid-term corporate bonds at present. If this strategy makes sense for your TFSA, ask your financial advisor for quotes on suitable bonds. Remember, most advisors only have access to a limited range of bonds and prices may vary from those quoted on-line. But if you aim for a return of 5.5 per cent or better on a 4-6 year bond, your advisor should be able to find some with a credit rating of BBB or better.

Gordon Pape’s new book is The Ultimate TFSA Guide: Strategies for Building a Tax-Free Fortune. Save 27 per cent off the suggested retail price by ordering your copy here.

Photo © Carmen Martínez Banús