T-Series offers retirees tax-free distributions

(December 2007) As more boomers inch toward retirement, helping them save enough cash is becoming increasingly important. That’s why most mutual fund companies now offer a T-Series class fund — a relatively new option for people who want their distributions tax free.

The T in T-Series stands for tax-advantaged, and it’s easy to see why. When a T-Class mutual fund pays its distribution to investors, most of the cash that’s doled out is considered return of capital (ROC), which is not taxable.

“Return of capital is the most tax-efficient form of cash flow in a cash flow stream,” says Stephen Fiorelli, vice-president of marketing at Franklin Templeton. “You’re essentially giving investors their money back in the form of cash flow but still allowing their investments to grow and compound.”

“What is return of capital?” asks Jamie Golombek, vice-president, taxation and estate planning, at AIM Trimark Investments. “From a tax perspective, it’s the amount someone receives that’s neither income nor capital gains.”

But the investor’s receiving ROC, and drawing down capital, doesn’t mean his or her number of shares decreases. Instead, the adjusted cost base goes down until it hits zero. At that point, the investor will have to start paying capital gains on the money received.

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Most of the fund companies that offer T-Series funds give investors a couple of different return options. Mackenzie offers a T6 and T8, or a 6% and 8% return, while other companies such as AIM Trimark offer 4%, 6% and 8% options.

Why not offer a higher return? “You can put it at 20%, but you’re really going to start eroding your capital fast if you do that,” says Fiorelli. “We don’t want to set them too high or play with them too often. People who buy these vehicles aren’t looking for a percentage; they’re looking for ‘X’ dollars to fund retirement or pay for a trip.”

The T-Series offering is relatively new, with most companies launching these products in the past four or five years. But it’s taken until this year for the tax-saving option to take off. That’s because more people are moving closer to retirement, and this product is largely designed for seniors.

“We have a huge group of people that are going to retire, and it’s these people that need consistent predictable tax-efficient monthly income,” says Derek Green, president of CI Financial, which has the T-SWP option on 25 of its funds.

He says the days of double-digit GICs are long gone and that people approaching retirement are not saving enough, so seniors should look at products that don’t generate capital gains. “Not everyone has a nest egg big enough to generate enough income to live off of,” says Green. “So they’re going to need products where maybe they are cutting into the nest egg, but they’re not making sufficient capital gains.”

Brian O’Neill, a senior fund analyst at Morningstar Canada, says T-Series products are intended to be used outside a registered account, useful if the retiree is drawing a pension or an RRSP is maxed out.

This tax-efficient vehicle might sound too good to be true, and, for the most part, it is a great way to get extra income in retirement — but it’s not perfect. “I would caution investors that the investment is only as good as the fund itself and the manager running it,” says O’Neill.

That’s because if the fund underperforms, the original asset base will decrease. If the fund performs poorly for an extended period of time, and the investor is forced to draw down his or her ROC, then the net asset value (NAV) per share will drop significantly. “That’s why fund companies reserve the right to lower distribution in certain years,” O’Neill explains.

As well, investors shouldn’t think that they’re getting away without paying any tax at all. Golombek points out that “ultimately, what you’re doing is deferring that tax to a later point in time. So the risk is [that] at the end of the day when you sell the fund or when you die, there’s a deemed disposition. In some cases, paying that big capital gains tax could put someone into a higher tax bracket.”

It’s also a little misleading to say that T-Series distributions are completely tax free. When paired with a mutual fund trust, monthly distributions are usually mixed with ROC, interest and other taxable income, which means investors will be forced to pony up some cash.

But many companies offer the T-SWP as part of their corporate class offerings, which minimizes these other taxable factors and allows distributions to be composed of only ROC.

The corporate class structure works well with T-Class because it allows investors to move between funds without triggering a deemed disposition. Green uses an example of someone who initially invested $10,000 20 years ago. Today, that person’s planning to retire and wants to start receiving regular distributions, but that original investment is now $500,000. Instead of paying capital gains on distributions, that client can move his or her cash to a T-Series — without causing a deemed disposition — and start receiving tax-free ROC distributions on the half-million dollars.

“By switching to the corporate class, an investor can have an effective, predictable, tax-efficient flow of money back to them,” says Green.

This option is especially important for retirees receiving OAS and GIS payments. If a deemed disposition is triggered, they could be forced into a higher tax bracket, which would affect these retirement benefits. Tax-free ROC will keep the payments as they are.

More Ahead of the Pack

• Up to speed: An overview of tax changes for 2007 • Documentation checklist • Talking to clients: Tax changes for 2007 • Canadians fail tax quiz • To Clients: Tax deadlines are looming • To Clients: The year in review • More tax planning reading, resources and tools

Back to Ahead of the Pack mainpage

While a lot of companies offer a variety of funds in the T-Series option, not everything works with this class. Specifically, volatile funds that invest in emerging markets are best avoided by the T-SWP structure.

“I’m a big believer that when you make investments in emerging markets, it should be done on a dollar cost basis,” says Green. “When it comes out, it should be in a lump sum, and you have to be very strategic or tactical on when you pull it out. If we went through something like the 1994 peso crisis or in 1998 where the market was annihilated, you’ll be taking out units when the market’s down. You’ll be lowering your ACB, plus the… NAV is blown down.”

Fiorelli agrees that emerging markets and T-Series don’t go hand in hand. “You don’t want to put this in a high-risk investment where you have erratic returns, where it’s hard to predict what that cash flow will be year to year,” he explains.

Green says government bonds aren’t a match either. If a 10-year bond yields 4% after expenses, the 5% distribution, which most companies offer as their lowest return option, means “this thing is going underwater.”

Overall, it appears that T-Series funds are the way to go for retirees or Canadians looking for some extra income. But are they really as good as they sound? “It seems that way,” says O’Neill. “We’re seeing a lot of new T-Class launches.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(11/27/07)