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The Companion Advisor: Taxes & Estates
Don't overtax your income
At some point, you will need to turn your retirement nest egg; into a portfolio of income-producing investments. There are many ways to do this, but it is important to understand the tax implications of the different options that are available to you.

Provided by Manulife Financial
A Companion Advisor article

From a simple savings account to the complex world of income trusts, many different income oriented investments can provide you with money to cover day-to-day expenses. Various investments have the potential for a guaranteed rate of return on your investment, while others can provide tax-efficient income and the potential for long-term capital growth.

By reviewing your overall financial situation with your advisor, you will be able to determine the right product mix to suit your immediate and long-term income needs as you enter into retirement.

INCOME AND TAXES GO HAND IN HAND

The first step towards understanding how to produce sustainable income is to learn how the different investment options are taxed. As Chart A illustrates, the amount of after-tax income you can receive is highly variable.

INTEREST INCOME

Income received from employment, pensions and guaranteed interest rate investments such as bonds and GICs is taxed at the highest rate in Canada. If you were to invest your entire nest egg in bonds and GICs, your investment income would be guaranteed, but this security comes at a cost.

DIVIDENDS AND CAPITAL GAINS

Dividend income can be obtained by holding investments in corporations that pay out income on a regular basis from their earnings. Capital gains are the profits that you realize when you sell a capital asset for a price that is higher than the purchase price.

Assumptions: Based on 2008 highest tax bracket (federal and Ontario) of 46.41 per cent; tax rate on
eligible dividends including the dividend tax credit of 23.96 per cent and capital gains tax rate of
23.20 per cent. For illustration purposes only.

As we can see from Chart A, these potential sources of income are taxed much more favourably than interest income from bonds and GICs. The downside of these investments is that they do not guarantee your principal investment or the level of income you will receive. In other words, unlike a GIC, it is possible to lose money if market volatility undermines the value of your investment.

If you are willing to take some additional risk by foregoing these guarantees, income derived from dividends and capital gains has some distinct advantages. Assuming you are in the highest tax bracket, you would retain $7,604 out of every $10,000 paid as dividends, and $7,680 if the income were derived from capital gains. This compares very favourably to the $5,359 you would obtain from any security bearing interest income.

RETURN OF CAPITAL

Investments that are structured to provide return of capital payments can be very tax-efficient from an income point of view. A return of capital occurs when some or all of the money you have in an investment is paid back to you, thus decreasing the value of the investment. This is not a gain of any type because it is not in excess of the original investment. In other words, a return of capital payment is simply a return of your own money to you that is free of interest, dividends and capital gains, and therefore attracts no tax.

The downside of return of capital payments is that for every payment you receive, the adjusted cost base of your investment decreases. The adjusted cost base is the cost of your investment for tax purposes and is used to calculate your capital gain (or loss) when you redeem your investment. When your adjusted cost base reaches zero, all further distributions will be taxed as capital gains.

FINDING THE RIGHT BALANCE

A number of investment funds have become available that specialize in producing tax efficient income that is paid on a monthly basis

Deciding on the right investment is a difficult decision. Some of us prefer the security provided by traditional, guaranteed interest rate investments such as bonds and GICs as opposed to the ups and downs of the financial markets. The problem with these securities is that in today's low interest rate environment, the after-tax return you would receive front these securities would barely keep up with inflation.

To help get around this problem, a number of investment funds have become available that specialize in producing tax-efficient income that is paid on a monthly basis. These funds are able to meet this objective by investing their assets in a number of complementary asset classes to help reduce investment risk. In most cases, these funds will not provide a guarantee on your principal investment, but they are managed very conservatively to ensure the fund produces a sustainable income.

MONTHLY INCOME FUNDS

In general, investment funds that are designed to provide monthly income invest in a number of different asset classes to help provide sustainable returns. These funds typically invest in a combination of corporate and government bonds, stocks and income trust securities. Because these funds invest in these various types of securities, they are able to produce regular income that is more tax-efficient than the interest income that you would earn from a bond or GIC.

The following table includes examples of a one-year GIC, a five-year bond and a hypothetical monthly income fund to illustrate the difference in after-tax income.

INVESTMENT TYPE	INCOME FROM INVESTMENT	TAXATION	ANNUAL AFTER-TAX INCOME
One-year GIC $1,000,000 @ 3.00% interest rate	$30,000	Current year Interest income $30,000.00 x 46.41 % = $13,923.00 Dividend income $0 x 23.96% = $0 Tax-deferred income = $0	$16,077.00 Tax payable when GIC is sold $0
Five-year bond $1,000,000 @ 3.50% yield	$35,000	Current year Interest income $35,000.00 x 46.41 % = $16,243.50 Dividend income 0 x 23.96% = $0 Tax-deferred income = $0	$18,756.50 Tax payable when bond is sold $0
Hypothetical Monthly Income Fund $1,000,000 C @ 4.44% yield	$44,400	Current year Interest income $13,757.75 x 46.41 % = $6,384.97 Dividend income $14,383.10 x 23.96% = $3,446.19 Tax-deferred income = $16,259.15	$34,568.84 Tax payable when fund is sold $3,772.93
Assumptions: Based on 2008 highest tax bracket (federal and Ontario) of 46.41 per cent; tax rate on eligible dividends including the dividend tax credit of 23.96 per cent; tax-deferred income (return of capital) is taxed as capital gain tax rate of 23.20 per cent upon sale. The purpose of this illustration is to demonstrate the difference in taxation of these investment types and is not meant to be a comparison of investments.

SPEAK WITH YOUR ADVISOR

If you are looking for a way to turn your retirement nest egg into a reliable income stream, it pays to shop around. Monthly income funds that are designed to provide tax-efficient income can be an excellent addition to an investment portfolio.

To find out whether a monthly income fund is an appropriate addition to your portfolio, it is best to speak with your advisor. He or she will work with you to discuss your current financial situation and determine your overall tolerance for risk. After a careful review, you may find that a monthly income fund will be a worthwhile component of a well-diversified portfolio designed to provide income during your retirement years.

Notice: Fiscal Agents Financial Services Group are not engaged in rendering tax, accounting or legal professional services or advice. The comments in this article are not intended, nor should they be relied upon, to replace specific professional advice. Before acting on material contained herein. Readers should seek advice that is appropriate to their personal circumstances from a professional advisor.

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