How to Have Cash at the End of it All
If you are planning to live to 100, you better make sure you don't outlive your money. One way to do that is to ensure you have the most tax-effective source of retirement cash. Here are a few ideas:
Perhaps the easiest way to guarantee a steady cash flow in retirement is to buy a life annuity. It's straightforward: You give a lump sum to an insurance company and they promise you a monthly amount for the rest of your life.
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Mechanically, an annuity can be thought of as a mortgage in reverse: In the early years, the monthly mortgage payment consists mostly of interest and little principal repayment. In later years, the interest portion is lower and the principal repayment portion is higher. The same holds true with annuities. Early annuity payments consist mainly of interest and later payments primarily of capital.
There is a significant tax advantage with a "prescribed annuity," a non-indexed annuity purchased by an individual with non-registered funds (outside of an RRSP or RRIF). It qualifies for special tax treatment under the Income Tax Act that permits the tax liability to be split over the life of the annuity, setting a prescribed taxable amount that never changes.
So, rather than paying tax on a large portion of the annuity payments in the early years, when the proportion of interest income to capital payment is very high, the tax burden is spread out over the life of the annuity, resulting in extremely tax efficient, guaranteed cash flows until death.
Of course, the biggest problem with an annuity is that once you've given your funds to the insurance company, your capital is gone. Should you die the next day, your payments will cease immediately unless you've also purchased a minimum guaranteed term. Naturally, the cost of such a guarantee would lower your monthly annuity receipts.
What if you want to leave your capital intact for your beneficiaries? If you combine the annuity purchase with a permanent term-to-100 life insurance policy, you can use a portion of the monthly annuity payments to pay the premiums on the policy, thereby insuring both the value of your capital while maintaining a guaranteed tax-efficient cash flow for the rest of your life.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
Another tax-efficient source of retirement cash, albeit not guaranteed, is a systematic withdrawal plan (SWP) set up on a mutual fund account. Under a SWP, you request periodic payments from the account and each payment triggers a redemption or sale of mutual fund units or shares. In the early years, the majority of your withdrawal will constitute a non-taxable return of your own money. Later, the withdrawals consist mainly of tax-efficient capital gains.
For even greater tax efficiency, many fund companies offer T-series versions of their funds that allow investors to receive automatic monthly distributions at a set percentage, ranging from 4% to 8%. The distributions are generally designed to be entirely "return of capital," making them non-taxable. As a result, they reduce the investor's adjusted cost base, resulting in a tax-deferred capital gain when the fund is ultimately sold or upon death.