Tax treatment of a systematic withdrawal plan (SWP)

This commentary deals with the tax treatment of the income received from a systematic withdrawal plan (SWP) from a non-registered investment fund where the rate of return is a constant 5% per year. Receiving income in this manner can be very tax efficient since only a portion of the income stream is taxable as a capital gain and the balance will be treated as non-taxable return of capital. In addition to the taxation of SWPs, there may be distributions or allocations reported, depending on the investment fund, which also needs to be taken into account.

Consider the after-tax Income

This chart illustrates how $10,000 of income from different sources is reported on a tax return and how much is remaining after tax.

SWPs—how to calculate the tax due

At the time of each withdrawal, there’s a sale of units to fund the withdrawal. This sale will trigger a capital gain or loss. To determine the amount of the capital gain or loss, you must look at the adjusted cost base (ACB) and the growth/loss (fair market value minus ACB). The diagram below shows an example of how this is calculated, assuming a $200,000 deposit, growth of 5% ($10,000), and a $10,000 withdrawal at the end of the year.

The diagram illustrates how to calculate the capital gain and return of capital when fund units are sold. In this example, the growth represents 1/21 ($10,000/$210,000) or 4.76% of the total fair market value (FMV) and the ACB represents 20/21 ($200,000/$210,000) or 95.24% of the FMV. Therefore, 1/21 or 4.76 cents of each dollar realized because of the sale of units will be considered a capital gain and 20/21 or 95.24 cents of each dollar will be considered a return of capital (which isn’t taxable but reduces your ACB). Note that specific calculations will depend on the growth/loss and ACB at the time of withdrawal.

Taxation of SWPs in an up market

In this example, 4.76% of any withdrawal is a capital gain and 95.24% is a return of capital. If we assume a $10,000 withdrawal, this results in a capital gain of $476 (4.76% * $10,000).

Since the capital gain is only $476, the effective tax rate in the first year is less than 1% and you’re left with $9,905 after tax.

Note: In a down market, SWPs from an investment fund will erode capital.

GIC equivalent

The previous example reflects the results after one year. What if the example was extended for 40 years? Let's continue with the assumptions of a $200,000 deposit, 40% marginal tax rate, 5% annual rate of return, and 5% withdrawal at year end (so $10,000 of annual growth and a $10,000 withdrawal at year end). This way, the FMV remains at $200,000, equal to the client’s original deposit amount.

As the table below shows, in a growth market, more of the withdrawal is considered a capital gain in subsequent years. However, even in year 40, the effective tax rate on the annual withdrawal is still less than 20%. The GIC-equivalent column represents the interest rate needed on a GIC to get the same amount of after-tax income for that year.

GIC equivalent with distributions or allocations

In addition to the assumptions above, the table below takes into account distributions or allocations from the investment fund and assumes distributions or allocations equal to 20% of the fund return and a tax rate of 25% on the distributed or allocated amount. As expected, accounting for distributions or allocations increases the effective tax rate but the effective tax rate is still less than 20% in year 40.

Distributions or allocations can impact the ACB, which in turn affect the taxation of SWPs. For more information on calculating your ACB, see our article: “An investor’s adjusted cost base: A moving target.”

Borrowed money and SWPs

Caution must be taken when setting up a SWP with borrowed money. Many people use borrowed money for investment purposes and then use withdrawals or distributions from the investment to pay the monthly interest costs, or for personal expenses. The Canada Revenue Agency (CRA) will trace your borrowed money to where it’s being used today, and if it’s no longer used to earn income (e.g., to pay interest on a loan or for personal expenses), then the interest deduction will be proportionally reduced.

Our “Interest Deductibility—Use Returns of Capital (ROC) Carefully” article is a real-life example of how a taxpayer learned this lesson the hard way. In this case, the taxpayer used part of the distributions of return of capital from his leveraged investment for personal use (i.e., not to earn income and, therefore, a non-deductible purpose) and lost part of his income deduction. The same principle applies to the portion of withdrawals considered return of capital.

How it works—an example

An individual borrows $100,000 to invest. Over time, the investment grows to $150,000. If the investor redeems $50,000 and uses the proceeds for a non-income-producing purpose (e.g., for personal use), the individual will lose one-third ($50,000/$150,000) of the deductibility of any remaining interest costs.

Even though $100,000 remains in the investment (which is the amount of the loan), the CRA has stated that the proportional method is appropriate for identifying what portion of the borrowed funds have been disposed of.

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1 Line 275 in Quebec. 2 Assumes an effective tax rate of 25% — will vary by province. Dividends paid by public corporations qualify as eligible dividends and are included at 138%. Non-eligible dividends are included at 115%. 3 For this article GIC refers to insurance-company-issued guaranteed interest accounts (GIAs) as well as bank-issued guaranteed investment certificates. 4 Taxable portion will vary depending on age — approximated for a 65-year-old female 5 Assumes $200,000 invested, 5% annual rate of return ($10,000), and a systematic withdrawal payment of $10,000 at year end. Represents results for year one, grows to 20% in year 10; doesn’t take into account distributions or allocations. To see later years with distributions or allocations, see the “GIC equivalent with distributions or allocations” table. 6 Regular Series T distributions are expected to be all or principally return of capital, which isn’t taxable until the adjusted cost base falls to zero, at which point it’s taxable as capital gains — doesn’t take into account any potential taxable distributions.