New option reduces your tax bill

Need income? Don’t like paying taxes? Take a look Fidelity’s new T-SWP program for non-registered portfolios. Don’t be put off by the strange name. It could save you a lot of money.

SWP stands for systematic withdrawal plan. Every major fund company offers SWPs but Fidelity has gone one better with the introduction of “T” units for its Canadian Balanced Fund, Canadian Asset Allocation Fund, and Global Asset Allocation Fund. When you invest in one or more of them, you’ll receive tax-efficient monthly cash payments, currently running at a rate of $0.10 a unit.

Fidelity says that most of this cash flow will be treated as “return of capital” for tax purposes. That means that no tax is payable on that amount in the year the money is received. Tax is deferred until you sell your units or until the adjusted cost base (ACB) falls to zero, whichever comes first.

The ACB is determined by subtracting the amount of tax-deferred payments received from the original price you paid for the units. So, for example, if you buy units in the Canadian Balanced Fund at $13.63 (recent net asset value) and receive $1.20 in tax-deferred distributions over the next 12 months,he ACB will be $12.43 ($13.63 – $1.20). That’s the price that would be used to calculate your capital gain or loss if you should sell at that time.

Postpone taxes for years
No tax is payable on return of capital income until you dispose of your units or the ACB falls to zero. So this plan allows you to postpone taxes for many years. Let’s say you buy T units of the Canadian Balanced Fund at $13.63 and the monthly payments continue at $0.10, all of which is considered “return of capital”. It will be about 11 years before the ACB reaches zero.

At that point, you could sell at the fund’s then-current NAV. Let’s suppose that it has doubled, to $27.26. That figure would be your capital gain for tax purposes. However, only 50 per cent of that is actually taxable, at your marginal rate. If you’re in a 45 per cent bracket, you’d pay tax of $6.13 per unit at that time. That would leave you with a net capital gain of $7.50 per unit plus $13.20 in tax-free distributions over the period. Plus, of course, you’d have your original capital available to re-invest.

The company stresses that the $0.10 monthly distribution is not guaranteed and will be adjusted from time to time. The aim is to keep the cash flow in a range of 7.5 per cent to 9 per cent of the fund’s net asset value (NAV) each year.

Based on prices at the close on Oct. 22, the Canadian Balanced Fund is currently paying at a rate of 8.8 per cent of NAV, the Canadian Asset Allocation Fund at 9.1 per cent, and the Global Asset Allocation Fund at 10.1 per cent. A downward adjustment in the payout of the Global fund could take place soon, since it is well above the target range. Fidelity says they are watching this particular fund closely but don’t plan any immediate change in the distribution because of market volatility. Nonetheless, be aware that this can happen any time when the payouts move too far above or below the targets.

The company says that it will likely launch “T” units for some of their other funds in future, which would be useful for investors who want more diversification in their portfolios.

Obviously, T-SWP funds should only be used in non-registered portfolios. Putting them into an RRSP, RRIF or similar retirement plan would negate the tax advantage they offer.

But for investors, such as retirees, who require steady cash flow from non-registered accounts and who are in higher tax brackets, this new concept is well worth investigating.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that offers expert advice on selecting funds and building a winning portfolio.