Consider T-Series for tax-efficient cash flow

There are important tax differences between income and cash flow. Income is reported on an income tax return and generates a tax liability, whereas cash flow is not reported, and does not trigger tax.

Investors have two means to generate tax-free cash flow from investments: making withdrawals from a TFSA account, and holding T-class Corporate Class mutual funds in non-registered investment accounts.

Read: TFSA: Not always a simple decision

More on T-class funds

T-class funds provide a monthly distribution consisting of Return of Capital (ROC). Most T-class funds allow investors to withdraw up to 8% of the fair market value of their shares determined at the beginning of each year, or a fixed dollar amount annually. Any ROC distributions in excess of a client’s needs can be reinvested; thus, ROC can be customized to what the client needs in a given year.

ROC distributions reduce the adjusted cost base (ACB) of the T-class fund for tax purposes. Capital gains are eventually triggered when shares of the T-class fund are sold, or when the T-class fund’s ACB eventually reaches zero.

Read: Optimize after-tax income

Investors who may be interested in T-class funds

Clients who don’t want to trigger income from their investments but may need or want to access capital should consider T-class funds. Such clients may include:

people in top marginal tax brackets who need access to cash flow, but don’t want to trigger additional income;
retirees looking for cash flow to meet lifestyle needs prior to receiving CPP or OAS;
retirees who want additional cash flow without having to be concerned about triggering OAS clawback;
people, trusts or corporations looking to fund expenditures, such as life insurance, without triggering income and having to fund the expenditures with after-tax dollars;
trusts that need to generate capital to distribute to identified capital beneficiaries tax efficiently; and
any investor wanting flexibility and access to cash for unplanned expenditures without having to worry about triggering capital gains unnecessarily and who can simply reinvest any unneeded ROC payments.

Case study #1

Consider a recent widow with a net worth of about $12 million. That includes a $1-million RRIF, $5-million in Holdcos and $6-million in non-registered investments (Account A). She wants $350,000 in after-tax funds every year ($100,000 for herself and $250,000 to support two sons) and a new will providing a $3-million bequest to charity. The remainder will be divided evenly between her four children.

Previously: To generate $350,000 in after-tax funds, she and her husband were each withdrawing $150,000 from their respective RRIFs; the remainder was funded by liquidating non-registered investments.

Suggestion: She should continue drawing $150,000 from her RRIF for $100,000 of after-tax income, with any extra withdrawn to be invested in a TFSA or non-registered investments. Then, she should carve off $3.5 million from Account A, transfer it to newly created Account B, and invest Account B in 8% T-series funds.

The first $250,000 in ROC from Account B will cover the support for her two sons, and any ROC remainder can be reinvested. Her advisor should check Account B quarterly to ensure its FMV always exceeds $3 million so that it can fund the $3-million bequest without having to dip into other funds. Her new will should contain a provision stating Account B will be the source of the $3-million charitable bequest.

Result: Sons’ support is funded with cash flow, not income, which means less income tax paid on an ongoing basis, and more remaining for investment and estate planning purposes. Upon the widow’s death, any capital gains generated through donating Account B will have an inclusion rate of 0%, as the account will be donated in-kind, and her terminal tax return will also reflect the donation of $3 million, reducing income taxes otherwise owing.

(Also read: Gift life insurance, get tax credits)

Case study #2

A newly retired couple, both 60, have combined RRSPs of $750,000, combined TFSAs of $90,000, and joint non-registered investments of $500,000. They want a combined annual after-tax income of $60,000 to support retirement lifestyle needs.

Suggestion: Convert some or all of their RRSPs into RRIFs. Both spouses should withdraw $25,000 per year from their respective RRIFs for five to 10 years. As well, arrange for $15,000 in ROC annually from non-registered investments invested in T-class funds. The ROC amounts will act as a bridge until CPP and OAS starts. Any ROC not needed for lifestyle spending can be reinvested.

Result: The RRIF is drawn down in a controlled manner, lowering their average tax rate over the long term. This provides flexibility and control with respect to when CPP and OAS starts; access to cash flow which provides flexibility in dealing with retirement lifestyle surprises. The couple has lower reported income, which means lower income taxes, translating into more investment assets.

Case study #3

Mr. Birch, a widower, has two daughters. He owns 100% of Birch Opco (Opco) and has $1 million in non-registered investments. One daughter, Eva, has worked with her father in the Opco over the last 15 years. His other daughter, Brenda, lives out of province and has been a stay at home mom for the last 12 years raising her three children.

Mr. Birch has recently met with his advisors to discuss his estate. He’s decided to allocate Opco to Eva, which has a FMV of $2 million, and purchase a $2 million life insurance policy naming Brenda as beneficiary. The premium on the life insurance is $25,000 annually. The remainder of his estate will be divided equally between his two daughters.

Suggestion: Mr. Birch is already in the top marginal bracket from salary and dividends received from Opco, which support his lifestyle needs (he is generous and enjoys life). To cover the life insurance premiums, he should invest $500,000 of his non-registered investments in T-series funds with 5% ROC; the $25,000 in ROC received will be used to fund the life insurance premiums annually.

Result: Life insurance premiums addressing his estate planning intentions are funded tax-efficiently with cash flow as Mr. Birch is not triggering additional taxable income at top marginal rates to cover those premiums.

Michelle Connolly, CPA, CA, CFP, TEP, is a Toronto-based tax and estate planning expert.