Withdrawal strategies

Here is a situation that could be described as a financial advisor’s dream. An advisor has been referred a well-to-do retired couple who are seeking a second opinion on their finances. Their main goal, naturally, is to generate enough income to keep them in the style to which they have become accustomed. But, they also want to maintain capital for estate planning purposes, even though their grown children are financially secure. This couple has numerous accounts – RRIFs, LIFs, non-registered accounts, TFSAs, and savings accounts – and has been withdrawing money from all of them. Now they want advice to organize an effective withdrawal strategy that would help them meet their objectives.

For any advisor, such a referral would provide an extraordinary opportunity to help prospective clients with asset allocation and withdrawal issues. You’re not only helping them to enjoy their capital, but to preserve it. Just pondering this situation got me thinking about the potential advisors have to help clients save by developing a tax-efficient withdrawal strategy. To get the best after tax return for a given level of risk, it matters not only which assets are withdrawn, but when. If it’s done properly, your clients’ retirement cash flow can be greater, and their portfolios can last longer.

Seven steps to tax efficiency

So how can you achieve tax efficiency? I’m going to suggest a seven-point plan, a withdrawal hierarchy if you will. The model is based on combined federal and provincial income taxes and the caveat is that it should be tailored to individual situations and goals. For example, a couple’s estate planning goals could alter withdrawal strategies. Generally, clients should be encouraged to consult tax advisors with respect to their specific situation and needs when implementing these measures. Assuming a constant tax rate, here they are in descending order of priority:

1. Withdraw only the required minimum from matured registered accounts (RRIFs, LIFs and LRIFs)

For any of your clients, this is the first consideration because of mandatory minimum withdrawal requirements imposed by the Canada Revenue Agency (CRA). Withdrawals from all registered accounts, including annuities purchased with registered-account proceeds, are taxed as ordinary income and fully taxable. However, minimum withdrawals can also provide tax savings thanks to the non-refundable pension credit on the first $2,000 of pension income.

The important point is that registered account withdrawals should be kept to the prescribed minimum. As we’ll see in the following sections, additional cash flow can be obtained from non-registered accounts or TFSAs. Once these options are exhausted, clients should consider making withdrawals above the required minimums from their registered accounts.

2. Liquidate losses in non-registered accounts

If investments in non-registered accounts are worth less than their cost base for tax purposes, your clients can sell portions of them to offset current capital gains. Equally, their losses can be applied against capital gains earned in the previous three years, thereby reducing current or prior-year taxes. Unused capital losses can be carried forward, but can only be applied against taxable capital gains.

A tax savings opportunity that is often missed occurs where capital losses on shares or debt of a small business corporation qualify as a business investment loss. Up to 50% of a business loss can be applied against ordinary income. To determine if a business loss will qualify for this favourable treatment, a tax expert should be consulted.

Investors should bear in mind that the investment merits of a disposition generally trump potential tax benefits.

3. Liquidate non-appreciating investments and cash balances

I’m talking here of investments such as money market funds or other cash-equivalent investments in non-registered accounts. Since withdrawals from these investments primarily constitute returns of capital invested, generally, they are non-taxable. These assets originated from after-tax funds and are not subject to tax again. However, if cash-equivalent investments are the main source of these withdrawals, clients will have to retain sufficient liquid assets to cover any short-term financial emergencies. They must also consider potential rebalancing issues.

4. Draw down tax free savings accounts (TFSAs)

The big advantage in making withdrawals from TFSAs rather than other investment accounts is that they are tax free. As well, TFSA withdrawals will not impact OAS clawbacks or other income tested benefits. The trade-off is that your client will lose some of the tax advantage of growing investments inside the TFSA.

5. Set up a tax-efficient SWP for non-registered accounts

First, a word about systematic withdrawal plans in general. Clients typically set up SWPs to obtain cash flow from non-registered accounts, which may hold various types of assets. Traditional SWPs redeem a percentage of an account’s holdings in each period, producing a distribution consisting of capital gains (50% of which are subject to tax), income from the underlying investments, and the return of original capital.

Naturally, the tax efficiency of this income depends on the underlying investment that produced it. Dividend income is more tax efficient than interest income, because the dividend tax credit lowers the client’s effective tax rate to boost after-tax income. This year, for example, an Ontario resident subject to the highest marginal tax rate will have an effective tax rate of 26.57% on dividend income, well below the 46.41% marginal rate on interest income. In this case, a diverse portfolio of equities, bonds and cash will better preserve assets and support tax-efficient withdrawals than a portfolio consisting only of bonds.

There is a refinement to the traditional SWP called the tax-efficient SWP. Instead of redeeming units and triggering capital gains, tax-efficient SWP service providers distribute non-taxable returns of capital. This capital is then blended with income earned to generate cash flow. A tax-efficient SWP drawn down at the appropriate rate can provide more durable income than cash investments. In fact, depending on market conditions and the relative performance of the funds within the tax-efficient SWP account, the balance could continue to grow – even with high regular draw downs. Eventually, of course, the adjusted cost base (ACB) of the investments in the plan’s non-registered accounts will decline to zero, and the tax-deferral benefit disappears. But even after ACB falls to zero, further withdrawals will be treated as capital gains which are taxable at half the rate of interest income.

6. Trigger capital gains in non-registered accounts

When clients dispose of assets from non-registered accounts, accrued gains are included in income at a rate of 50%. Such income is more tax efficient than ordinary income from either interest bearing investments or from the distributions of registered accounts. An individual subject to a marginal tax rate of 46.41% on normal income (interest or pension income, for example) would face a capital gains tax rate of only half that amount on redeemed appreciated assets from a non-registered account. The tax efficiency of this option is greater when capital losses are carried forward to offset the gains.

7. Withdraw from registered accounts

Deferred tax vehicles such as RRSPs and RPPs should be used as much as possible to save for retirement but it’s important to remember that eventual withdrawals are going to be taxable as ordinary income, making these plans the least tax-efficient sources of retirement income. Clients would be well advised to consult with tax advisors to determine if they have more money in tax-deferred, registered savings accounts than they’ll need to cover essential expenses in retirement.

Withdrawal strategies need to be customized

The general guidelines I’ve discussed above are useful starting points for client withdrawal plans but however they proceed, your clients should remain true to their overall investment strategies, balancing asset allocation with tax-efficient withdrawals.

Portfolio rebalancing may become an issue, especially if they make withdrawals from a single asset class. In this case, the portfolio may have to be adjusted to avoid significant capital gains. In some cases, current taxes may be avoided by exchanging securities within tax-deferred, registered accounts. Alternatively, non-registered investments may be placed within a capital class structure, allowing a rebalancing across funds within the structure while avoiding taxable dispositions.

Every situation is unique, and the decisions clients make should place long-term goals ahead of immediate advantage. By all means, they should consider tax issues when making withdrawals but maximizing the after-tax proceeds from all sources of income is not solely about achieving the smallest immediate tax bill. Long-term asset allocation is key and when it comes to developing this perspective, tax advisors can be of great help to your clients in designing individual withdrawal strategies.

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