SWPs – Systematic withdrawal plans

Tax treatment of non-registered account decumulation

During accumulation, investors enjoy a tax deferral when the price of their holdings increases. In tax terms, this is known as an unrealized capital gain, and works whether securities are held directly or within a mutual fund. In this article, we’ll use mutual fund examples and terminology.

Later, if the money is not needed all at once, it will usually be taken as a series of annual draws, known as a systematic withdrawal plan (SWP). This spreads the tax by allowing continuing deferral on the remaining investment.

Tax deferral with unrealized capital gains

In registered accounts such as Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), investors are entitled to tax-sheltered growth regardless of the type of income that is earned. There is also no tax as the investment value varies, but when withdrawals are taken, each dollar is fully taxable.

For non-registered accounts, interest and dividends are taxable in the year earned, as are capital gains that a mutual fund realizes and distributes to investors. Changes in the price of underlying securities will cause a mutual fund’s value to change, but no tax arises out of such fluctuations. But when there is a redemption/sale of the fund by the investor, that is a taxable event. And if the fund’s value has increased in the interim then the investor will realize a capital gain at that time. That capital gain is equal to the fund’s fair market value (FMV) minus the investor’s adjusted cost (ACB), the latter being discussed in greater detail under the next heading.

Fortunately, only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying what is known as the income inclusion rate. That rate has ranged between 1/2 and 3/4 since 1971, but has remained stable at 1/2 since 2000. Now, in accordance with the 2024 Budget, the rate has again risen to 2/3, but the 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

Adjusted cost base

An investor’s ACB begins with the amount invested, averaged across multiple purchases. For example, if one mutual fund unit was purchased last year for $4, and one unit this year for $6, the total ACB is $10, which works out to $5 average per unit. The total value as of the second purchase is $12, including an unrealized capital gain of $2.

The “adjusted” part of ACB includes such things as acquisition costs on each transaction, and income that is not distributed but instead reinvested. Notably, the investor is still taxed on reinvested income as if it had been distributed, with the ACB increase ensuring that the investor is not taxed a second time on a later disposition.

Redemption, portion, proportion

As a capital gain is an addition to invested capital, you could think of it as a chocolate-dipped soft ice cream cone. When it comes time to consume it, you could be taxed as if you licked off all the chocolate first (that’s the added portion), or each bite could be treated as some ice cream and some chocolate.

Eating preferences aside, it is the latter biting version that more closely resembles a mutual fund redemption. Each redemption has two portions: ice cream in the form of a non-taxable return of capital (ROC), and chocolate dip that is treated as a realized capital gain. The proportion of each on a given redemption is based on the size of the redemption in relation to the ACB and the current market value. This is best illustrated by looking at a few scenarios.

SWP scenarios

Suppose you inherit $100,000 from a great aunt and decide to use it to supplement your monthly income by $500, or $6,000 annually. You choose a mutual fund you expect to earn a consistent 6% annual return, all in unrealized capital gains. To keep the focus on the SWP effect, we’ll simplify the arithmetic by having you take your withdrawal at year-end rather than monthly. Your marginal tax rate is 40%.

Scenario 1 – Equal withdrawals, maintaining principal

In this first scenario you intend on preserving that $100,000 for your children, so you’ll take withdrawals equal to the investment return. Here’s what it looks like in the first year, with figures rounded to the nearest dollar:

After that first-year withdrawal, the ACB is reduced to $94,340 to account for the $5,660 ROC, but you still have $100,000 invested. The second year’s withdrawal will net to $5,868, for an effective tax rate of 2.2%. It will take over 100 years for the effective tax rate to round to the actual 20.0% rate on taxable capital gains.

Though you will have maintained the principal amount invested, the continuing reduction in the ACB means that an increasing portion of your investment will be taxable. If you never sell, there will still be a deemed disposition at your death (though this could be deferred by rolling it at ACB to your spouse), before passing on to your children as desired.

Scenario 2 – Equal spendable withdrawals, depleting principal

Instead of allowing the net withdrawal to be reduced each year, you may prefer to have a consistent after-tax spendable amount. If you want $6,000 in your hands, you would need to withdraw/redeem more than that in order to account for taxes. That would only be another $69 in year 1, but the extra amount would increase each year.

While this slowly depletes the principal, even at year 25 you will still have about $70,000 invested.

Scenario 3 – Indexed withdrawals, eventually exhausting principal

As the years roll on, the flat amount of withdrawals under either of the preceding scenarios will lose purchasing power due to inflation. Rather than passing on the principal to your children, your priority may be to use this money to take care of your own living expenses. To do so, you could index the withdrawals each year.

The current inflation rate recommended in the 2024 FP Canada Projection Assumption Guidelines is 2.1%. At that rate, you could sustain an indexed $6,000 spendable withdrawal from $100,000 of principal for about 25 years.

Canadian dividends provide investors tax-efficiency

Home bias with a rational rationale

Investors are often comforted by investing in what is familiar. For Canadians, that may include investing a greater share of their portfolio in Canadian securities.

Whether or not it is intentional, this home bias can provide benefits beyond comfort, by also rewarding the investor from a tax perspective.

WHAT – Focus on non-registered investments

In a registered account like a Registered Retirement Savings Plan (RRSP), there is no tax distinction among the types of income. No tax applies to the income earned within the plan, then all withdrawals are fully taxable.

It’s different with non-registered accounts, where the method and amount of tax varies according to the type of income. In these accounts, Canadian dividends are tax-preferred, especially for those at low to middle income.

WHY – Corporation adds a taxpayer level

The recipient of any income is responsible for paying tax. If all income was earned directly by individuals, or natural persons, then things would be straightforward.

However, there are also artificial persons—or corporations—which may first earn and pay tax on income before passing it on to real people. The way it is passed on by the corporation is by paying dividends to its owner/shareholders, in this case the portfolio investors.

HOW – Integration mitigates double-taxation

With both individuals and corporations being required to pay tax on the income they receive, there is a risk of double-taxation. This is further complicated by the way each is taxed: corporations are taxed at a flat rate, and individuals pay tax at graduated rates that get progressively higher as income rises.

To reconcile this two-stage taxation, our system has a set of rules that integrates personal and corporate taxes. It’s known as the integration model and it has two main components:

1. Gross-up –A dividend received by a shareholder from a Canadian corporation is increased by an arithmetic factor designed to add back the taxes paid by the corporation. By doing so, it’s as if the investor earned the income that was really earned by the corporation. This ‘taxable’ dividend is what is used to calculate the investor’s initial tax liability – but wait…
2. Dividend tax credit – Another arithmetic factor is then applied to reduce the individual’s tax liability by the estimated tax that the corporation has already paid. The government has only collected part of its revenue from the corporation, so in effect the investor is topping that up.

For investors in low to middle income brackets, this can result in much less tax than would apply to interest income or foreign dividends. And at very low income, the credit may exceed the tax as calculated above, allowing the excess credit to be applied against tax otherwise due on the person’s other income. The combined effect of the gross-up and dividend tax credit are shown in the table on the next page.

History – Two types of Canadian dividends

For decades, one set of factors for gross-up and tax credits applied to all Canadian-source dividends. But since 2006, dividends from a corporation that has paid its taxes at the general corporate rate have been entitled to more favourable ‘eligible’ gross-up and tax credit rates. This better recognizes the revenue the government has already collected from Canadian public corporations, and in turn provides relief to investors on taxation of the associated dividends received in their portfolios.

By contrast, where a corporation has used the small business rate, the ‘ineligible’ gross-up and tax credit rates apply. These are mostly owner-operator businesses, so not the type of dividends normally earned in an investment portfolio.

Governments adjust the gross-up and dividend tax credit figures occasionally, to maintain alignment with any changes in corporate tax rates.

Illustration – Eligible dividends in a non-registered account

This following table shows the combined federal-provincial marginal rates for a dollar of income, without breaking over bracket thresholds. Figures are rounded to integers for ease of relative comparison of the income types, though actual rates may have more decimal places.

WHY NOT – Foreign dividends

Comparatively, dividends from foreign corporations are fully taxable to Canadian investors. A foreign corporation will have paid tax to its own government. As Canada receives none of that revenue, there is no reason for it to give a credit on foreign dividends paid to Canadian residents.

My Money Mirror comes into 2020 focus

Published version: Linkedin

From the Today Show to The View and innumerable points in between, Barbara Walters’ voice has been heard by millions of us over the last half century or so.

And while it’s hard not to conjure up Gilda Radner’s “Baba Wawa”, the iconic phrase that the real Barbara is best known for is her crisply enunciated welcome to the ABC TV newsmagazine 20/20. Of course the show title is an allusion to 20-20 visual acuity, which her careful phrasing so effectively captures.

This all came to mind for me as we turned the calendar over into the current 2020 year and decade, while reflecting on My Money Mirror.

What is My Money Mirror?

Whether it came out of a dream or is a remnant of a sci-fi/fantasy moviescape (or both), I’ve long had this notion of a money mirror out in the distance before me. It runs infinitely from left to right, and I’m always moving steadily toward it.

At a younger age, it doesn’t even appear that there’s a mirror at all. Being so far off, it could very well just be continuing sky. But as time and I myself roll forward, a dot appears on the horizon that grows and begins to take form, eventually blocking part of the view. I want to see past it, but as I drift to the left, it follows my move. Then I tack to the right, and it matches me again.

What is this thing, and why is it getting in my way? And that’s when it comes to me — it’s me.

Why a mirror?

Unless you were born into large wealth, you will spend much of your early life saving up a store of your excess labour — what we call money — that will be needed to sustain you in your later life. At some point you will (hopefully) cross over from the need-to-save to the freedom-to-spend. Maybe that’s more like an inflection than a reflection, but then my cute aliteration would be lost, so I’m sticking with my money mirror.

It’s the notion of retirement being the point at which there is enough stored wealth to comfortably and confidently fund the rest of your life. That’s a very different thing from merely reaching a chosen age or ceasing to work. The mirror is a way of visualizing the distinction between the purpose of your journey and the observations along the route.

Specifically, I want and need to visualize who I am on the other side of that divide. Ideally the image will be sharply defined well before reaching the mirror’s surface. Otherwise, without adequate preparation I might find myself on a collision course with an ever-growing dark mass with undulating edges —yeah, maybe this did originate as a nightmare.

Practical reflections on the year, and decade that was

The blurry blob aside, this journey toward clarity truly is the background visual when we look over the family finances each year-end. Note the “we” in that sentence, as this really is a team exercise.

Years ago when I was on my own, my attention was simply on saving something. I had no particular goals other than to be in a regular and reasonably informed habit, and I don’t apologize for that. To require more of a young person could lead to a very unhealthy stressful relationship with money.

These days as a couple dependent on one another and a family to raise, we have to be that much better informed and more targeted. We’re also learning from our experiences, so we have better intuition without having to be constantly looking, but we still run the numbers.

The difference this year is that it’s also a decennial marker, as we enter 2020. Looking back at our net worth progress over the last decade gives us confidence as we pivot from past to future. There’s no question that we’re still on the journey, but things really are getting clearer by the year.