Systematic fund withdrawal may save taxes but cost you your capital

You will improve on your over-all fund performance if you take a less-than-systematic approach to withdrawing from your life savings for your retirement income.

Many mutual-fund management companies offer services that can help investors organize their affairs. Some of these services may be of great assistance to the investor, while others tend to benefit the fund company more.

Convenience may add value

Systematic withdrawal plans appear to offer a convenient way to turn any mutual-fund investment into an income generator. What’s more, the plans carry some apparent tax advantages. So they seem to be a good thing.

Systematic withdrawal plans, offered by most mutual funds, can provide a convenient way to turn your investment into a stream of income. But this method of doing so also has a marked disadvantage over other ways of going at the problem of generating investment income.

How systematic withdrawal works

The essence of systematic withdrawal is quite simple. You ask the fund company to redeem, say, a specific dollar amount of units in your fund at regular intervals such as monthly or annually. Of course, you may have taxable capital gains on the units you redeem.

All mutual funds let you withdraw up to 10 per cent of the value of your investment annually without triggering deferred sales commissions.

Keep tabs on the amount withdrawn versus the amount the fund earns

The real concern for investors considering this plan, however, should be that the amounts withdrawn not exceed the amount the fund earns each year. That’s important, because if you withdraw more than your investment in the fund earns, the earnings base for succeeding years will become smaller, leading to smaller dollar-value earnings in future years.

Of course, that may not matter to you if you’re not interested in capital preservation. If you are, however, you’ll have to ensure that you withdraw no more than the earnings of your fund each year.

You may, therefore, have to set your income relatively low, or change the amount of your withdrawal from time to time, as your fund’s returns vary. In years such as 2008, when the average Canadian equity fund lost 34.2 per cent for the year, that would mean actually putting money back into the fund.

The tax advantage

The tax advantage of systematic withdrawals stems from the fact that much of the income, in the early years of an investment, comes from the sale of assets that are likely to have accumulated little in the way of capital gains. The usual approach to a systematic withdrawal is to have all dividends reinvested automatically, and to redeem shares periodically to generate cash. But investors must still pay tax on those dividends. It’s the accumulating capital gains that remain unrealized in the fund that results in postponed taxes.

Why systematic withdrawal is not suitable for most conservative investors

But if you’re a conservative investor, a systematic withdrawal plan in an equity fund is probably not right for you, regardless of the tax advantages. That’s because equities are vulnerable to prolonged downturns that could play havoc with your investment. Fixed-income securities, however, at least provide a guarantee.

The opposite of dollar-cost averaging

Remember, too, that the withdrawal of a fixed-dollar amount on a regular basis is actually the opposite of investing through dollar-cost averaging. The plan results in selling more units when values are low and fewer units when values are high. That’s the opposite of the ideal of selling high.

Our advice: take a less systematic approach

We think you will improve on your overall performance if you take a less systematic approach to withdrawing from your life savings for retirement income.


The TaxLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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