Comparing SWPs to Series T funds—pay tax now or later?

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 depending on whether the return is positive or negative. Receiving income this way can be tax efficient when returns are positive, 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). However, the ROC received reduces the adjusted cost base (ACB) dollar for dollar.

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 until the ACB reaches zero. After that point, future 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 60, 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 29.3 years.

For illustration purposes only. For customized results, refer to the Series T Corporate Class Calculator.

At the end of 29.3 years, Dave and Betty each received the same gross cash flow of $133,347. Since Betty was invested in a Series T fund, she was able to receive more tax-free ROC and, as a result, received $10,333 more after-tax cash flow during the 29.3 years. If Betty chooses to continue with Series T, going forward, she’ll pay more tax each year on the income stream than Dave.³ 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 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. 2 The assumed distribution is paid annually in December and comprises 100% capital gains dividend. 3 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.