Building tax-free income using Canadian dividend-payers

Volumes of articles have been written about the TFSA and RRSP, which one is better for your retirement savings. 

Potentially, if you’re in a low tax bracket it might make sense to use the TFSA.  You maximize your TFSA while growing RRSP contribution room and when your income rises, you can start contributing to your RRSP to defer tax and lower your marginal tax rate.  If you’re already in a moderate or high tax bracket you might consider using both accounts; do your best to defer taxes now (RRSP) and also defer taxes forever (TFSA). 

What I’d rather write about today, is our evolving approach to use our TFSAs as a haven for Canadian dividend-paying stocks. 

With the TFSA contribution room jumping up another $5,000 this past January, we’re going to add more dividend-paying stocks to these accounts in 2011 and beyond.  After looking at the numbers and some minor tax implications, we couldn’t think of many reasons not to. Sure, we will lose any ability to claim the Canadian dividend tax credit but then again we’ll earn juicy dividends tax-free.  The latter seems better to me.   Unfortunately we’ll have some capital gains to pay in the 2011 tax year but that can’t be avoided from what I understand unless we’re transferring stocks into the TFSAs at a loss. When unregistered shares are moved to the TFSA, our friends at the Canada Revenue Agency considers the shares sold at their fair market value (FMV) and the shares bought in the TFSA at their fair market value. This means I will have a taxable capital gain next year.  On the other hand, if I transfer shares at a lower price than I paid for them, the capital loss will be denied because I cannot apply this loss against a capital gain.  When it comes to the TFSA, a loss is just that. This is the minor tax implication I referred to above; not the end of the world.

My plan over time is to transfer some of my Canadian dividend-payers into my TFSA to shelter the dividends paid.  I’ll keep some stocks unregistered as the contribution room rises and/or when we can afford to buy some different dividend-payers for the TFSA.  We’re trying to save for the future but also pay off our large mortgage debt and live for today, so we need to strike a balance here.  In any event, I’ve got a few dividend reinvestment plans (DRIPs) running to make optional cash purchases of Canadian stocks when I want to, commission-fee, so I’ll continue that process to build up my volume and diversified list of dividend-payers. When I have some free contribution room in 2012 and the following year, I’ll slide a few stocks into the TFSA.  As TFSA contribution room continues and hopefully rises, I will deplete some of my unregistered holdings.

The plan is to have some tax-free income as we get older, hopefully rising income at that from great companies like TransCanada, Bell, Enbridge, Bank of Nova Scotia and Fortis who have rising earnings and reward their shareholders accordingly every year.

Another bonus to sheltering the dividend income in our TFSAs?

TFSA withdrawals in retirement won’t be considered income in the eyes of the Canada Revenue Agency.  This means TFSA withdrawals will not affect government benefits such as OAS (Old Age Security).

With TFSAs there are certainly many options. Instead of debating all the pros and cons of each, take what you can from this government gift and seize the advantages of both tools in your financial planning toolbox.

What do you think of our strategy? 
What are you planning to use your TFSA(s) for?

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