Corporate class mutual funds: reduce OAS clawbacks

Scenario

Jane recently retired from her position at a pharmaceutical company and is looking forward to the years ahead. Turning 65 years old next year, she’ll be receiving a defined benefit pension from her employer, Canada Pension Plan (CPP)¹ payments, and the Old Age Security (OAS) pension, which together will total $90,000.

As her employer pension was quite considerable, Jane had negligible registered retirement savings plan (RRSP) contribution room available and, therefore, holds her savings in a non-registered account worth $500,000. Jane’s investment generates taxable income of approximately $20,000 annually, which will bring her total net income next year to $110,000. Given that she’ll be eligible to receive the OAS pension next year, Jane wants to know if her level of income will affect the amount of OAS that she’ll be eligible to receive.

The clawback issue

While individuals who’ve reached age 65 may qualify for a monthly OAS benefit payment, this benefit can be clawed back if too much income is reported on line 23400 of their federal income tax return. For 2023, OAS pensioners with net income above $86,912 will begin to have their OAS clawed back and it’ll be fully eliminated when their net income reaches $142,800. This amounts to a 15-cent clawback on every additional dollar of income between $86,912 and $142,800, as shown in the chart below.

Since Jane's anticipated net income will exceed $86,912 next year, she can expect her OAS to be reduced below the maximum OAS pension benefit. Accordingly, Jane would like to look at possible ways to reduce her reported income to minimize the OAS clawback.

Solution: invest in a corporate class mutual fund

By using a corporate class mutual fund, Jane can better manage her taxable income in retirement since a mutual fund corporation can only distribute ordinary Canadian dividends, capital gains dividends, or return of capital (ROC). Jane could invest in a corporate class mutual fund that’s not expected to distribute ordinary Canadian dividends.⁴ This way, all the distributions she may receive would be either capital gains dividends, which are 50% taxable, or ROC that isn’t subject to tax.⁵

Here’s how it works

Jane decides to invest the $500,000 of non-registered funds in a corporate class mutual fund. The fund is targeted to yield 4% this year.⁶ In addressing Jane’s concerns over the OAS clawback, we compare Jane’s $20,000 of investment income being treated as ordinary Canadian dividends with a 138% inclusion rate,⁷ interest income with a 100% inclusion rate, capital gains with a 50% inclusion rate, and ROC that’s not taxable.

Outcome: lower OAS clawback

As seen in the previous chart, by receiving the $20,000 of investment income from a corporate class mutual fund as either capital gains or ROC, Jane is able to reduce the resulting OAS clawback to $1,500 or $0, respectively. Since the corporation can’t distribute interest income, this avoids a larger OAS clawback of $3,000. This is in addition to any tax savings realized by receiving capital gains or ROC, which are taxed at more favourable rates than interest income.

It should be noted that ordinary Canadian dividend income results in the largest OAS reduction of $4,140. This is due to the 138% inclusion rate or gross-up.

An additional benefit to consider when investing in a corporate class mutual fund is the pooling of expenses. A mutual fund corporation can offset the income and capital gains of one fund with the expenses and capital losses of another, potentially reducing or deferring taxable distributions to investors.

For more information on Manulife’s corporate class mutual funds and how they can help, speak to your advisor or refer to our related article, “Ideal candidates for mutual fund corporations.”

1 Quebec Pension Plan (QPP) in the case of Quebec residents. 2 Income on line 23400 of the federal income tax return. This income includes OAS. 3 OAS value is an approximation. OAS is taxable. 4 Ordinary Canadian dividend income is the least income-friendly for OAS purposes. Although it receives preferential tax treatment through the dividend tax credit, a grossed-up amount is included in total income, inflating the total income on line 23400 and negatively impacting the OAS clawback and other government income-tested benefits and tax credits (such as the age credit). 5 Distributions of ROC aren’t taxable and reduce the adjusted cost base (ACB) of the investment. However, once the ACB reaches zero, additional ROC distributions are taxable as capital gains, which are still tax efficient since they’re only subject to a 50% inclusion rate. 6 Distributions aren’t guaranteed. 7 Dividends paid by public corporations generally qualify as eligible dividends and are included at 138%. Non-eligible dividends are included at 115%.