Can Your Clients Benefit From T-Series Funds?

One of the key benefits of a Tax-Free Savings Account (TFSA) is that it allows Canadians to generate tax-free cash flow, since both investment growth within a TFSA and withdrawals from a TFSA are tax-free. However, contribution limits mean there’s a ceiling on the amount of tax-free cash flow TFSAs can provide. Fortunately, T-Series Corporate Class mutual funds (T-Series funds) can provide additional tax-free cash flow from investments in non-registered accounts.

T-Series funds provide a monthly distribution that consists of tax-free return of capital (ROC). Every year, most T-Series funds allow investors to withdraw up to 8% of the fund value or a fixed dollar amount. Any ROC distribution that exceeds the investor’s needs can be reinvested, making it possible to customize cash flow to what an investor needs each year.

ROC is a distribution of cash flow, not income. Because it is a return of the investor’s capital, every ROC distribution reduces the adjusted cost base (ACB) of the fund for tax purposes. When an investor sells shares of the T-Series fund, or when the ACB of the fund eventually reaches zero, capital gains are triggered. That said, capital gains are generally more tax-efficient than other types of investment income, such as interest income.

It's important for wealth planners to consider income versus cash flow, and the flexibility and control that accessing cash flow provides from a planning perspective. After all, income is reported on an income tax return, generating a tax liability, whereas cash flow is not reported and does not incur tax.

The solution you propose to your clients will be based on what they are looking for from their investments, when they need access to a stream of money to fund their lifestyle expenses, and how each investment fits together within a diversified portfolio. The key to identifying the right recommendation for a specific client is to ask many questions about what they need and want today and in the future.

Who may be interested in T-Series funds?

T-Series funds may be appropriate for investors who are seeking growth potential and access to capital from their investments while minimizing taxable investment income. This may include:

• Individuals in high marginal tax brackets who need access to additional funds but don’t want it taxed as income at high tax rates.

• Retirees who want to supplement cash flow and meet lifestyle needs before they start to receive Canada Pension Plan (CPP) or Old Age Security (OAS) income.

• Retirees looking for additional cash flow without having to worry about triggering an OAS clawback.

• Individuals, trusts or corporations who need to fund certain expenditures, such as life insurance, without triggering income and paying after-tax dollars. 

• Trusts that want to generate a flow of money that can be distributed tax efficiently to capital beneficiaries.

• Any investor seeking flexibility and access to cash for unplanned expenses without having to worry about unnecessarily triggering capital gains and who can simply reinvest ROC distributions if they don’t need the money.

In any wealth plan, ROC can enhance flexibility and control over the nature of investment income and when it’s reported. It can also help smooth investment income, reduce income taxes paid and leave more invested without compromising investors’ cash flows.

The following studies are hypothetical and presented for illustrative purposes only.

Case A: The widow supporting two sons

A recently widowed woman has a net worth of more than $12 million, including $1 million in a Registered Retirement Income Fund (RRIF), $5 million in holding companies and $6 million in non-registered investments (Account A). She wants to generate $350,000 every year ($100,000 for herself and $250,000 to support her two sons). She’d also like to create a new will that provides a $3-million bequest to charity, with the remainder of her estate divided evenly between the two sons.

Previously, to generate $350,000 in annual after-tax cash flow, she and her husband each withdrew $150,000 from their respective RRIFs, with the rest funded by liquidating non-registered investments.

Recommendation

This client can continue to withdraw $150,000 from her RRIF every year, generating $100,000 in after-tax income. She can invest any extra money she doesn’t need in a TFSA or non-registered account.

Within Account A, it turns out a significant portion ($3.5 million) is sitting in cash, so transferring that money into a new Account B won’t trigger capital gains. Within Account B, she can invest this money in a T-Series fund paying out 8% in ROC distributions. The first $250,000 in ROC will fund support for the two sons. Any remaining ROC can be reinvested.

In the new will, Account B can be identified as the source of funding for her $3-million charitable bequest. It will be critical for her advisor to check Account B quarterly to ensure the fair market value exceeds the $3-million threshold to support the charitable bequest. Assuming a 6.5% annual return, the T-Series fund could support the two sons for more than 10 years before that threshold is breached.

Result

Support for the two sons 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, making the charitable bequest in kind means there won’t be any capital gains tax due on that amount. In addition, the terminal tax return will reflect the donation of $3 million, which will reduce income taxes owing on the rest of the estate.

Case B: The newly retired couple

A just-retired couple, both 60, have combined Registered Retirement Savings Plans (RRSPs) of $750,000, combined TFSAs of $90,000, and joint non-registered investments totalling $500,000. They want $60,000 combined to support their retirement lifestyle needs.

Recommendation

The couple can convert $500,000 of RRSPs into RRIFs, from which they can each withdraw enough to provide after-tax income of $22,500 annually. This takes care of $45,000 of the $60,000 they need.

To supplement this, they can arrange for ROC distributions of $15,000 annually for the next five to 10 years from T-Series funds in a non-registered account. This will provide a bridge until their CPP and OAS start. They can reinvest any ROC that they don’t need to cover their expenses.

Result

This approach smooths the couple’s income, since they will be withdrawing from their RRIFs in a controlled manner that will lower their average tax rate over the long term. They’ll also gain greater flexibility and control to decide when their CPP and OAS start. Most importantly, they’ll have the confidence of knowing they’ve set up the cash flow they need.

Case C: The father funding life insurance

A single father with a daughter and a son owns 100% of Z Opco and $1million in non-registered investments. The daughter has worked with her father in Z Opco for the past 15 years. The son lives in a different province and has been a stay-at-home dad for the last 12 years, raising his three children.

The father recently met with his advisors to discuss his estate. He has decided to allocate the value of Z Opco to his daughter and has purchased life insurance in the amount of Z Opco’s fair market value, $2 million, with his daughter named as beneficiary. The premium is $25,000 annually. The remainder of his estate will be divided equally between his two children.

Recommendation

This client is already in the top marginal tax bracket because of the salary and dividends he takes from Z Opco. To support his lifestyle needs, he can invest $500,000 of his non-registered investments in a T-Series fund with 5% ROC distributions. Of that amount, $25,000 in ROC can fund the life insurance premium.

Result

The ROC distributions efficiently fund the life insurance premiums required to realize the father’s estate planning intentions. Importantly, he will not be generating additional income taxable at the top marginal tax rate to pay these premiums.