Many investors have systematic withdrawal plans (SWPs) on their mutual fund or seg fund accounts that enable them to receive payments from their accounts on a regular basis. SWPs have been around for years and you may have been using plan examples published by many of the fund companies to illustrate the historical growth of assets underlying a SWP to your clients. With today’s low tax rates on capital gains, SWPs have become more popular than ever. What better time to review the tax rules governing SWPs and to provide a real life of example of how tax efficient SWPs can be.
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Taxation of SWPs – A Review
Each systematic withdrawal is considered a redemption of units of the underlying fund(s) in the plan. A capital gain or loss is calculated as the difference between the total proceeds received (i.e., the systematic payment) and the average cost of the units redeemed.
Average cost
The average cost per unit (technically referred to as the adjusted cost base or ACB) at redemption is the total cost at which all units were purchased before the redemption, divided by the total number of units outstanding at that time. The average cost per unit will not change as a result of redemptions. However, the average cost will change when additional purchases are made, including those purchases that are made from reinvested distributions received from a mutual fund. Unlike mutual funds, seg funds do not generally pay distributions. The seg fund allocates income and capital gains (losses) to the policyholder. This results in an increase (decrease) to the ACB of the seg fund units to ensure that these amounts are not taxed again on a withdrawal from the contract.
Distributions and allocations
Any income and capital gains distributed by a mutual fund or allocated by a seg fund have tax implications for the investor (seg funds can also allocate capital losses). These amounts must be included in the taxpayer’s return in the year of distribution or allocation.
The income portion may comprise a combination of interest, Canadian dividends and foreign non-business income. Interest will be taxed as ordinary income at the full tax rate.
Canadian dividends will be eligible for the dividend tax credit and the foreign non-business income may have a foreign tax credit attached to it. The distribution for mutual funds and/or allocation for seg funds may also have a capital gains component, which represents the gains realized by the fund through the sale of some of its holdings. The taxpayer must include 50 per cent of the realized capital gain on a disposition and the capital gain (or loss for a seg fund) received by distribution or allocation in income.
An example
Miriam has $300,000 to invest yet wants to make sure that she has $1,500 of cash flow every month to pay the rent.
Let’s say Miriam took her $300,000 and invested it in 30,000 units of a fund at $10 per unit. Being conservative, we’ll use a 6% annual rate of return and we’ll also assume that the money is fully invested in equity funds so that the returns are entirely in the form of capital gains. At the end of Year 1, the $300,000 grows to $318,000. Miriam withdraws the $18,000 and to make it simple we’ll assume that she takes it all out at the end of the year. (As a practical matter, Miriam would take out $1,500 per month to cover her rent.)
When Miriam withdraws $18,000 that means that she would actually redeem 1,698 units at $10.60 and the ACB of those units would be $16,981. In other words, her original cost of $10 has gone up by 6% so at yearend, it’s $10.60. Therefore, she would have to redeem that many units to get an even $18,000. Miriam’s capital gain is approximately $1,019, taxable at 50%. Since Miriam is in the top tax bracket in Canada (the average rate being about 45%), the effective tax on her withdrawal is only $230, which translates to an effective tax rate of 1.3%.
If we look at Year 2, Miriam’s investment is back to $300,000 at the beginning of that year, because at the end of year one, when the fund was worth $318,000, Miriam withdrew $18,000.
Note that when the calculations are rerun in Year 2, the effective tax rate is still extremely low (only 2.5%.) Eventually, after many years, that will creep up to approximately 23% as most of the ACB is slowly withdrawn from the plan.
Call to Action
As you can see, recommending a SWP to your clients can be a very tax effective method for providing a steady stream of cash flow to your clients while at the same time maintaining the original capital of the investment.