Neighbourly advice on tax-efficient income

Sooner or later, every homeowner is going to face the decision that my neighbour is about to make. She is of an age and life stage where it makes sense to sell her house and move into a home that requires less upkeep and physical demands.

Of course, deciding to move is only part one of her decision. Part two is deciding how best to use the sale proceeds to ensure her money will last as long as she lives, and perhaps leave something for her children. As an advisor, you can’t really help with the first part, but you can be of great assistance with the second.

Location, location, location

My neighbour is about 75 and has spent at least 40 years in the same house. She has raised her family against a backdrop of change that’s seen her once working class north Toronto neighbourhood evolve into a haven for renovation-minded young professionals.

Widowed two years ago and slowing down, but in generally good health, my neighbour is a prime candidate for a long retirement. If the actuaries are right, she has about a 50% chance of living another 11 years, and a 25% chance of living another 17 years. It’s important that the proceeds of her home last as long as possible to help cover her expense. Her home is dated, and increasingly she’s disinclined to spend her time and money on repair and maintenance.

She knows she’s sitting on a sizable nest egg (she and her husband bought the house in 1970 for $30,000, but it’s now assessed at well over $500,000). Even if her home is sold as a tear-down, its prime location guarantees a very substantial gain will be realized, even after factoring in costs ranging from legal fees and disbursements to necessary updates and moving vans. And because she’s selling her principal residence, the proceeds will be exempt from tax.

She wants to use her housing windfall as wisely as possible. She admits she’s no expert, but understands that, aside from longevity, her financial assets could be affected by the other key risks facing seniors: inflation; asset allocation; withdrawal rate; and health care costs. She plans to rent an apartment or condominium for as long as her health will allow. And while she doesn’t relish the idea, she knows that eventually she may need to move into a residence that provides additional care. This, she realizes, could be costly.

Introducing the T-SWP

As her financial advisor, you can help clients like my neighbor enjoy the proceeds from her house while preserving as much capital as possible for her children to inherit. Start with an examination of her basic plan. One of her children suggested she put the proceeds from her house into a GIC or annuity. Although, she would receive a steady stream of income, this option would mean she’d lack the flexibility to withdraw a lump sum portion of her savings should it become necessary. Another worry is that if interest rates remain low, her potential return isn’t attractive.

As an alternative, you could suggest she consider using a tax efficient systematic withdrawal plan. T-SWPs or T-Series, as they’re commonly known, would have some obvious benefits.

Think of a T-SWP as a more sustainable and more tax efficient version of a systematic withdrawal plan. Available through the purchase of a certain series of mutual fund a T-SWP provides unit holders a monthly distribution based on a specified percentage of the year-end net-asset value.

Distributions are primarily classified as return of capital – which are not taxable as they are returning the investor’s capital, and will reduce the adjusted cost base of the fund units, triggering a greater capital gain on redemptions of the fund units or when additional distributions are received after the unit holder’s adjusted cost base reaches zero. When this occurs, these distributions will be treated as capital gains, with the associated preferential tax treatment, while the assets remaining in the account will, for the most part, continue to be tax deferred.

A range of benefits

Compared to a systematic withdrawal plan, a T-SWP will, to a certain extent, trade off some stability of cash flow for enhanced sustainability—which thus addresses a key risk facing retirees. But by deferring taxes, the T-SWP is more tax efficient than an ordinary systematic withdrawal plan and, therefore, an attractive way to draw monthly cash flow from non-registered investments. Additionally, this tax deferral means an investor will either receive more after tax cash flow; or reduce the risk of erosion of capital.

Whether used on its own or as a complement to an investor’s retirement cash flow strategy, a T-SWP provides benefits to meet and potentially exceed your clients’ expectations. For example, not only do they provide sustainable cash flow, but often higher cash flows than many guaranteed investments. As well, it’s worth pointing out that the T-SWP’s market sensitive withdrawal mechanism can not only help preserve capital, but can also provide a measure of protection from inflation provided a moderate payout option is selected. They even have the potential to reduce government clawbacks on income based entitlement programs like Old Age Security. And remember, this is from an investment that isn’t locked in – unlike most GICs or annuities – and is widely available at no additional cost over that of owning a mutual fund.

If this isn’t enough to convince a client like my neighbour, you could mention the T-SWP’s investment planning versatility. A T-SWP is a nice complement to the guaranteed income of an annuity or a fixed income strategy. Unlike locked-in guaranteed investments, T-SWP units (like any mutual fund units) can be sold anytime in order to meet liquidity needs. If the investor’s cash flow needs change, the T-SWP can be adapted without incurring a tax penalty by switching part or all of their investment into a different payout option. The T-SWP’s tax deferral characteristic is also beneficial for investors who expect to be in a lower tax bracket in the future; when they can trigger a capital gain on redemption later in retirement. In this case, taxes deferred may turn out to be taxes diminished.

Not the only one

Now that my neighbour is about to sell her house, she wants to make sure the proceeds from the sale can produce higher cash flows than those offered by many guaranteed investments, especially in a continuing low interest rate environment.

What she wants is a tax efficient non-registered investment to meet her ongoing cash flow needs. I can almost see the smile spreading across her face as you tell her about the advantages of the T-SWP. And she’s not the only investor who will have that reaction. Many more will soon find themselves in her position, deciding to move forward to the next stage of life and in need of sound financial advice as they go.

Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC

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While the information provided may be intended to highlight various tax planning issues, it is general in nature. This information should not be relied upon or construed as tax advice. Readers should consult with their own advisors, lawyers and tax planning professionals for advice before employing any specific tax or investing strategy.

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