A tax-deferred solution that rivals RRSPs

Through the use of dividend-paying funds, clients engaged in a professional incorporation have a tax-deferment plan that may be more powerful than an RRSP for a select group of clients.

Professional corporations for high-net-worth clients such as dentists, doctors, accountants and lawyers have become a powerful way to shelter a retirement income. Using corporate class mutual funds, clients can defer tax on investments within the corporation.

Using a dividend payout class mutual fund structure – only available at Toronto-based fund firm, NexGen Financial – these clients can grow their money tax deferred through the life of their career, and then pay themselves a retirement income taxed as dividend income.

When it was launched three years ago, NexGen instituted a patent on the corporate class fund structure, which allows investors to switch between four different payout options, tax-deferred within the same corporate class fund mandate.

Currently, NexGen is the only mutual fund company in Canada to offer a fund option where clients can choose to have all their gains paid out as eligible Canadian dividends income – even if it comes originally from foreign companies. Dividend income is taxed at a much lower rate than other forms of distributions.

“Investors in the NexGen dividend tax credit class receive first priority when it comes time to allocate the dividend income at year end. Currently, about 6% of our assets are in that class so we have no difficulty ensuring the distributed income is 100% Canadian eligible dividends,” says Laurie Munro, president of NexGen Financial. “If a situation ever arose in a given year where the demand for the dividend class became extreme, we have the right, as a corporation, to declare a dividend out of the Fund’s undistributed gains.”

Why is such a product important for professionals?

According to John Horwood, first vice-president with Richardson Partners Financial Limited, it creates a very tax-efficient retirement “exit strategy” for clients in a professional corporation.

As long as a shareholder’s money’s in the corporation, personal income isn’t due until withdrawn by that director or shareholder. Professional clients can grow their money tax-free in the corporation. Taking it out can be tricky if the money isn’t paid out in a tax-efficient manner.

In Ontario, you can receive up to $58,000 in eligible Canadian dividend income, tax-free, assuming no other sources of income are present. According to NexGen, even if a client’s income exceeds $126, 264 a year, only 23.06% of that dividend income would end up being tax .

Horwood says that in working with his clients’ accountants, he’s been able to structure his clients’ affairs in a way that their corporation purchases the NexGen funds, grows them tax-deferred in the corporation and then has the corporation pay the client a retirement income in dividends.

“One of the challenges with [serving] professionals is you know a lot of their cash is trapped in the company. This strategy allows you to grow that money on a tax-free basis until the professional is ready to retire, and then pay it out, on a tax efficient basis, as eligible dividends to the professional and family members,” Horwood explains. “It’s a better substitute than an RRSP for many professionals.

In fact, if structured properly, Horwood says a retired professional and his or her spouse could take out $140,000 out their corporation tax-free before they even started paying tax.

The one-two punch of tax-deferred gains, then paid out as dividends, can significantly expand the time horizon of a retirement portfolio. Horwood, who uses this strategy in nearly 40 professional client accounts, projects that by using a relatively conservative rate of return, say 5%, and 12-year time horizon, his client’s portfolio – projected to be $922,223 – will last an additional 14 years as opposed to a conventional retirement strategy that uses a 6% dividend payout each year.

This strategy works on the assumption that the structure of the NexGen funds is able to meet the payout demands of all its investors. So far, the firm has had no issues meeting the distribution needs of clients and has successfully filed audited tax returns to CRA for the three past years. And it’s corporate class funds have not paid out a single surprise distribution.

The tax-deferral part of the strategy could probably be executed using another brand of corporate class mutual funds, but there isn’t really any other mutual fund company that promises a no-distribution option than can be converted within the structure tax-free into eligible Canadian dividend income upon retirement.

There are examples of corporate class mutual funds paying distributions to a higher-than-normal amount of taxable events with the corporation. The corporation will have to pay the appropriate tax on these distributions.

Dennis Tew, senior vice-president and chief financial officer with Franklin Templeton Investments, outlines that you could choose one of corporate class funds his firm offers, and grow them within the corporation, switching between different investment mandates if needed.

When it comes to payout, Tew suggests you could use a series-T version of one of Franklin Templeton’s corporate class funds, which would create a monthly income stream of tax-free return-of-capital income – allowing the client to liquidate the investments in the portfolio for a retirement income.

“Series T would allow the client to get regular cash flow without actually having to sell the units of funds,” Tew says. “Keep in mind, the client will be limited to the amount of cash they take out, probably between 4% to 7% per year. They’re not going to get a big [lump sum] dividend coming out of the portfolio.”