When it comes to planning for an income stream during retirement, Canadians are presented with many options. For non-registered investors, the tax treatment of investments is an important consideration.
One popular investment option for generating income is mutual funds. They can provide an income stream using a systematic withdrawal plan (SWP), or they may offer a Series T option (also referred to as T-Class). Both choices provide tax-efficient cash flow during retirement; however, Series T has the potential to defer more tax until some future time.
We’ll compare receiving a non-registered income stream from a SWP versus using a Series T option.
Comparing a SWP to Series T
At the time of each SWP, there’s a sale of units to fund the withdrawal. This sale will trigger a capital gain or loss. Receiving income this way can be tax-efficient since only a small portion of the income stream is taxable as a capital gain; the balance will be non-taxable return of capital (ROC).¹ However, the ROC received does reduce the adjusted cost base (ACB) dollar-for-dollar.²
With Series T, the payments are treated as distributions, and therefore, no units are sold and capital gains aren’t realized. These distributions are expected to be primarily ROC and, as previously mentioned, will reduce the investor's ACB. The receipt of ROC is tax free until the ACB reaches zero, at which point additional distributions that are reported as ROC are taxed as capital gains.
In either situation, there may still be taxable distributions reported. These should be the same or similar if the underlying fund is the same.
With a SWP, assuming a positive annual rate of return, the amount of the capital gain realized on the sale of the units will generally start small and grow over time as more ROC is received and the ACB is ground down. Series T distributes all the ROC first, at which point, future ROC distributions are taxed as capital gains. Assuming taxable distributions to be the same, Series T provides a tax deferral in the early years, but higher tax reporting in the later years once the ACB reaches zero. Interestingly, the net tax payable upon cashing out would be the same.
When deciding which option is better, you need to consider the impact of inflation (which can make future tax payments cheaper), the marginal tax rate of the investor both today and in the future, and the impact on income-tested benefits, such as Old Age Security.
The following example will help illustrate the timing difference from a tax perspective.
A tale of two tax-efficient income streams
Dave and Betty, both age 65, have each accumulated funds to invest for their retirement. Dave decides to invest $100,000 in a mutual fund and receives payments using a SWP. Betty also invests $100,000, but instead decides to allocate her funds to the Series T version of the same fund. Here’s how each of their portfolios look after 18.6 years.
What it looks like after 18.6 years (when the ACB reaches zero with Series T)
At the end of 18.6 years, Dave and Betty each received the same gross cash flow of $119,812. Since Betty was invested in a Series T fund, she was able to receive more tax-free ROC and, as a result, received $9,019 more after-tax cash flow during the 18.6 years. If Betty chooses to continue with Series T, going forward, she’ll pay more tax each year on the income stream than Dave⁵. Also, when Betty sells, she’ll face a higher tax bill on the unrealized capital gains, as compared to Dave.
In the end, both Dave and Betty will end up paying the same amount of tax on their respective investments. Dave ended up paying more tax earlier, whereas Betty will pay more tax later.
Caution: If the fund earns less than it pays out, the investment value will decrease, and with Series T, the annual payout amount will also decline.
1 For the purposes of this article, we assume a positive rate of return and that a sale of units will trigger a capital gain. If the rate of return was negative, the sale of units would generally trigger a capital loss. 2 For more information on the taxation of SWPs, see “Tax treatment of Systematic Withdrawal Plans (SWPs)” (MK2329E). 3 Series T monthly distributions are based on a target distribution rate of the net asset value per security of the fund determined as of December 31 of the prior year. 4 The assumed distribution is paid monthly and comprises 100 percent of interest income. 5 Betty can switch from Series T to another series or class of the same fund without triggering a taxable event, and defer the receipt of ROC and the resulting tax reporting until she or her estate sells the units.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. The payment of distributions is not guaranteed and may fluctuate. If distributions paid by the fund are greater than the performance of the fund, then your original investment will shrink. Distributions should not be confused with a fund's performance, rate of return, or yield. You may also receive return of capital distributions from a fund. Please consult with your tax advisor regarding the tax implications of receiving distributions. See the prospectus for more information on a fund's distributions policy. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.