A Simple Plan

I use RBC’s Direct Investing as my brokerage and have my portfolio set up to reinvest dividends. I’ve used and enjoyed this system for years, but TFSAs have me thinking about new strategies for the future.

What popped into my mind today is the possibility of using dividends as contributions to (and in turn investments within) a TFSA. This would also work as an RRSP strategy, but I’ll get into why I think TFSAs are perfect for this in a moment.

The idea goes as follows:  First you would turn off the automatic dividend reinvestment option (if it is enabled) so any dividends received would be deposited into your cash account. You would then transfer the cash into your TFSA. Just to keep things simple, and easy to track total deposits to the TFSA, you may consider using multiples of $5 (ie. a dividend of $26.25 would mean $25 into the TFSA, with the remainder sitting in cash until the next dividend).

As to why I think a TFSA is the better choice, it is because they are funded with your after-tax dollars. If you want to make a $1000 deposit, and you are in the 30% tax bracket, you would have had to earn about $1400 first. Since eligible dividends from Canadian companies are taxed at a lower rate, it seems to me that by using dividends to partially fund a TFSA, you would lower your effective tax rate at which TFSA investments would be made/calculated.

This is actually an adaptation of a plan I had some time ago, which in itself was based on Buffet: I had thought about using dividends in order to buy index funds in the same way Buffet takes the earnings and dividends from one company in order to invest in or buy other companies. Once the cash is in your TFSA, you could do like above and buy index fund units, or another strategy would be to save up for an equity purchase.

By using dividends from Canadian companies you get a tax advantage. Once you had a decent amount of cash stocked up, you could then buy a quality U.S. stock. You would have achieved a lower effective tax at which you bought the U.S. share, and then the only tax payable would be the 15% withholding tax on U.S. dividends.  Any capital gains would be tax-free (of course, any capital losses would be ineligible for use as a tax write-off).

Some more number crunching would be necessary to really come up with the pros and cons, but for now this seed of a strategy seems like it could blossom.

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