If you have built up an investment portfolio outside your RRSP, you must pay tax on any profits. Profits from these investments generally fall into either interest income, rental income, dividends or capital gains. Understanding the taxation of investment income is definitely the starting point of any non-registered investment plan. This topic deserves an article of its own (coming soon!).
Getting income from the non-RRSP dollars used to mean going to the bank and buying a GIC that paid out the interest to you instead of compounding it. Today, with lower interest rates and more concern about taxes, this strategy has fallen to the wayside. Earning 5% in interest, paying half to the government for taxes and finally adjusting for the cost of inflation leaves the investor no further ahead.
While this opportunity still exists, we must seek better uses of our money to create income.
Annuities provide more income
Annuities definitely pay more income. Why? The annuity is a fixed stream of income that pays out both interest and capital. The disadvantage of the annuity is the use and depletion of capital. If you are not concerned about leaving a legacy through your estate, the annuity is one of the best ways to maximize your income.
The biggest advantage to the annuity is the benefits of prescribed taxation. This defers the interest over the lifetime of the annuity giving you the benefit of deferring tax.
The annuity may be an effective tool for some of your assets but not necessarily all. Diversification is always prudent.
Systematic Withdrawal Plans (SWP)
GICs and annuities are guaranteed. They appeal to more conservative investors. Unfortunately, they are also sensitive to interest rates and with low interest rates, many income seekers are looking to alternatives.
Mutual Funds are one of the best starting points. With mutual funds, you can set up a Systematic Withdrawal Program where every month, quarter or year, you automatically determine a set amount of income. The income amount is arbitrary but investors often choose a reasonable target in hopes of providing income while maintaining capital. Many experts feel that 6% to 9% is a reasonable target.
One of my favorite examples is the Templeton Growth Fund where someone invests $100,000 and withdrawals $750.00 per month (the equivalent of 9%). Every month, Templeton sells $750.00 at the market price. Ask your financial advisor for more details. While Templeton has been a leader in marketing this concept, it can apply to any mutual fund. The most important thing to be said here is that aggressive marketing can sometimes omit the fact that mutual funds are not guaranteed and there can be significant fluctuations from time to time.
The one downside I will point out is that SWPs can work against you when markets tumble. In fact, to keep the same level of income, you will need to sell more units at lower prices. Selling more units at cheaper prices is the opposite of the golden rule of investing – buy low sell high.
Another alternative for mutual fund investors is the income fund. These funds are designed to pay a fixed level of income through a distribution. Unlike the SWP, instead of selling units every month, the administration is taken care of for you.
In my opinion, the accounting from a taxation perspective is a key advantage. Every buy/sell in a SWP requires that you calculate the adjusted cost base (ACB) which can be very cumbersome for the average person.
There are many different income mutual funds. Dividend Funds, Income Trust Funds and some balanced funds provide fixed dividends to provide monthly or quarterly income. Many of these investments are paying attractive yields in the range of 7% to 10%. They too are not guaranteed.
Individual Dividend Stocks or other securities
While mutual funds will appeal to a very broad range of investors, some investors might be more inclined to buy income producing investments directly. The most common choices are income trusts and dividend paying stocks.
There are many options for retirees looking to increase their income with non-registered investments. Understand the issues and implications so you can make the right choice.