Retirement Mistake No. 22: Not Taking Advantage of Tax-efficient Monthly Cash Flow Tax Strategies
Posted In: Retirement Planning for Entrepreneurs

A Secret Monthly Cash Flow System

Larry from Nanaimo dropped by to ask me how he could start the cash flow from his mutual funds.

I said, “How would you like to have a majority of  it paid to you tax efficiently?”

“Of course, but how can I do that?” Larry answered.

I replied, “Larry, if you’re looking for tax-efficient income solutions, here is an idea to think about. Set up a systematic withdrawal program (SWP).”

How It Works

The concept is simple: You withdraw a specific monthly amount from your mutual fund. Consider it the opposite of dollar cost averaging: A majority of the initial income is a return of  your own money or capital, which is tax-efficient. You can state the withdrawal either as a percentage of the fund’s value or as a specific monthly amount–say $500 per month. The fund will direct the deposit to your bank account each month, so you don’t have to worry about lost mail.

A specific dollar amount, rather than a percentage, is recommended, because the monthly income will not fluctuate. To help protect your money, you should consider withdrawing less than what the fund earns. It will help you keep pace with inflation and possibly increase the income in the future.

My experience is that most investors set up withdrawals of 4% to 6%, although you can set up withdrawals of  as much as 9%. (In such cases, we warn clients that they are increasing the risk of eroding the principal.) In an ideal world, Larry will withdraw 6% from a fund that is producing 7% to 8%. That way, the fund will continue to grow over time.

Larry and I chose balanced funds for SWPs, although you can also do it with other kinds of  funds. We chose balanced funds because they are highly diversified–with stocks, bonds, Government securities, cash, and sometimes even international securities. A bond fund is unlikely to consistently earn 7% to 8%, and a stock fund is too risky for clients who depend on investment income. Balanced funds form a nice, equitable plan for Larry’s retirement income needs.

Series T Strategies

As an investor looking for income, you probably already know about the stability and reliability that money market funds, GICs, and other fixed income investments can bring to your portfolio; however, the income you earn from these traditional fixed income investments is subject to the highest rate of taxation in Canada. Finally, the mutual funds industry has created a way to generate tax-efficient cash flow for retirees while assets can continue to grow. These are called “tax-class” or “Series T”strategies. (Some companies may have similar names and not all companies offer these tax strategies.)

Some of the benefits of Series T strategies are:

  1. High, predictable, and tax-efficient cash flow. Monthly Series T cash flow is targeted at a rate of  5% to 8% per year and is usually paid out monthly on the value of  each unit you own, which makes it a highly tax-efficient way for you to meet your regular income goals.
  1. Flexibility to customize your cash flow around your specific requirements. Switching between series of  the same fund or portfolio is not a taxable disposition. This allows you to fine-tune your cash flow to suit your changing needs. Most fund companies consider switching your investments around as a taxable disposition, which limits your ability to change your investments in the future. Ask your financial advisor whether this is an option for your non-registered investments.
  1. Continue to grow your assets. With a wide range of SeriesT funds and portfolios from which to choose, you can select a solution that provides you with the tax-deferred cash flow you need and the continued potential for growth of your portfolio.

How It Works

So how does Series T work? Return of  capital (ROC) is the key and allows you to defer 100% of the capital gains tax and enjoy a higher cash flow now.

We all want to minimize the amount of tax we pay on our investments. I’m writing this to tell investors about a strategy that will allow them to save for their retirement outside of their registered plans and still retain the benefits of tax-deferred compound growth–as well as the added bonus of tax-efficient withdrawals. Retirees who should consider this are:

-Those looking for tax-deferred cash flow and some growth on their investments outside RRSPs.

-Those topping up tax brackets with their income and planning capital gains.

-Those looking for cash flow that will not trigger Old-age Securities (OAS) program claw-backs.

Providing Tax-efficient Monthly Cash Flow

Investors today are wondering what they should do about their existing investments in mutual funds. They can stay invested, change now, or change later.

If you’re looking for investment solutions, here are two ideas to think about.

Set up a withdrawal program. You can use those funds for income, or you can reinvest into more conservative investments such as fixed income or bond funds to protect your capital.

Set up a tax-efficient systematic withdrawal program, or “T-SWP.” T-SWP investors enjoy a high level of monthly cash folw, from 5% to 8%. They also may have a reduced short-term tax bill.

We did the latter with Gerry, a retiree in Comox, about nine months ago. He had a balanced fund that was not performing well. While he wanted less risk, he didn’t want to change all of his investments at one time. We set up a T-SWP that pays Gerry a monthly amount. Then, we invest monthly into a bond fund to increase the bond holdings in his portfolio. Over time his bond holdings will increase and will make his portfolio more conservative. Gerry will want to take the income in the future, but for now he wants to try to preserve his capital.

The T-SWP works this way. Each month, investors receive a cash distribution of approximately 6% to 8% of the net asset value of the fund over a five-year cycle. These distributions consist primarily of return of capital. The return is treated as part of an investor’s original investment and therefore is not subject to tax. The tax advantage comes from the fund companies’ structures. The capital gains are taxable when units are sold or the original capital invested runs out. The investors have more control–they trigger capital gains instead of the fund company.

If you’re looking to make your portfolio more conservative, or for retirement income, it’s a good idea to do it over a period of time instead of all at once.

No man is happy who does not think himself  so. – Publilius Syrus

If  you can DREAM it, you can DO it. – Walt Disney


Published with permission from Grant Hicks

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