Similar to mutual fund systematic withdrawal plans (SWPs), income from Sun GIF Solutions Income Series and Sun Lifetime Advantage GIF is:

• funded by the sale of units, and
• paid to clients on a regular schedule.

Receiving income this way means that:

• just a portion of the income stream is taxable as a capital gain,
• the balance is a non-taxable return of capital, and

Taxation for non-registered contracts must consider both:

• regularly scheduled payments,
• year-end income allocations, and
• unscheduled withdrawals and fund switches, if applicable.

How it works

To understand how a client may be taxed, consider an example where:

• the client invests $250,000,
• the rate of return is a constant 4% per year, and
• the client’s lifetime guarantee income amount is $10,000 and they withdraw that amount every year.

Keep in mind that each income payment requires the sale of units to fund the withdrawal. This results in a capital gain or loss. To determine the amount of gain or loss, you need to consider the investment’s:

• adjusted cost basis (ACB), and
• growth/loss (i.e., current market value – ACB).

This example shows how it’s calculated based on a $250,000 investment.

• The client’s initial investment is $250,000 (from after-tax money), so their initial ACB is $250,000.
• At the end of year 1, the client’s market value has grown to $260,000.

Part A – Taxation of year-end income allocations

Segregated funds are required to allocate:

• interest,
• dividends,
• foreign income, and
• realized capital gains or losses

to clients in proportion to the units held by each client during the calendar year. These are reported to clients on a Form T3 (R16 in Quebec). Unrealized capital gains and losses aren’t allocated.

Income allocated to each client is also added to their contract’s ACB. Realized capital losses, on the other hand, are subtracted from the ACB.

In this example, at the end of the first year, $6,000 is allocated to the client as interest, dividends, and realized capital gains. The client is required to include the allocations in their income for the year and pay tax according to the type of income. The table below outlines the tax in this example.

To prevent double taxation on withdrawals the client takes, the allocations increase the ACB, in this case to $256,000 ($250,000 + $6,000).

Part B – Taxation of the income stream

At the end of the first year, the client withdraws their annual guaranteed income of $10,000.

For tax purposes, a withdrawal is treated as coming proportionately from the ACB and unrealized gains, if any. In this case, the market value is $260,000 and the ACB is $256,000.

The formula to determine how much of the withdrawal will be treated as ACB is:

ACB             
__________

market value   x withdrawal amount

In this example:

$256,000  
__________

$260,000  x  $10,000 = $9,846

This means that $9,846 of the $10,000 withdrawal will be treated as non-taxable ACB, or return of capital. The remaining $154 ($10,000 - $9,846) will be treated as a realized capital gain. Since only 50% of realized capital gains are included in income, only $77 ($154 x 50%) is taxable.

If the client is in the 45% marginal tax bracket, they pay only $35 ($77 x 45%) in tax on the withdrawal. This amount is in addition to any tax they pay on year-end allocations reported on their T3 (R16 in Quebec).

The withdrawal reduces the market value and the ACB. Immediately after the withdrawal, the market value is $250,000 ($260,000 - $10,000) and the ACB is $246,154 ($256,000 - $9,846).

Taxation in future years

In future years, even if the rate of return is a constant 4% each year with $6,000 in year-end allocations from the same types of income as in year 1, the tax on the $10,000 withdrawal would be slightly different due to the ACB changing each year.

For example, in year 2, if the client’s market value increases from $250,000 to $260,000 and the year-end allocations are $6,000 in the same proportions of interest, dividends, and realized capital gains as year 1, the ACB would be different since the allocations are added to a lower ACB.

• The pre-withdrawal ACB would be $252,154 ($246,154 + $6,000).
• The portion of the withdrawal representing ACB, or return of capital, would be $9,698 ($252,154 / $260,000 x $10,000).
• The client would have a $302 ($10,000 - $9,698) realized capital gain and include 50% of the gain in income for the year.
• This would result in $68 ($302 x 50% x 45%) in tax (versus $35 in year 1).
• Again, the tax paid on the withdrawal would be in addition to the tax paid on the year end allocations. 

Information contained in this article is provided for information purposes only. Its not intended to provide or be a substitute for professional, financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard. It also does not constitute a specific offer to buy and/or sell securities. Information contained in this article has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy.

The case studies and examples presented are hypothetical in nature and are provided for illustrative purposes only. Case studies and examples include certain material factors or apply certain assumptions to draw conclusions believed to be appropriate in the circumstances but are not intended to represent an advisor’s or investor’s personal scenario. Prior to making any decisions or taking any action, an advisor should conduct a thorough examination of their client's circumstances before implementing any of the strategies discussed herein as there could be additional complexities outside the scope of materials discussed in this article.

Any amount that is allocated to a segregated fund is invested at the risk of the contract owner and may increase or decrease in value.