An article about the advantages of Systematic Withdrawal Plans and the unique cash flow and tax advantages that they provide.

I believe that the “Systematic Withdrawal Plan” should be considered as the “Ninth Wonder of the World.” It has often been said that compound interest is the “Eighth Wonder of the World,” while others refer to it as the “Miracle of Compound Interest.” I am sure that most would agree, it does assist clients to reach their goals and in building wealth. If it is to be considered as the Eighth Wonder of the World then surely the Systematic Withdrawal Plan is the ninth. When it is time to start living off of the portfolio, the advantages of a “Systematic Withdrawal Plan” soon become apparent due to its tax advantages and the enhanced cash flow it can provide. Over the years using these plans for my clients to meet their requirements, I have come to feel that for financial advisors and their clients the Systematic Withdrawal Plan is in fact the “Ninth Wonder of the World”.

Many retired people who own individual securities receive dividends only on their investment and use that as their only investment income in addition to interest income to supplement whatever pensions they may be receiving. The problem is that this may yield only 2 or 3 percent income while the stock increases in value with an unrealized capital gain. The retired person is often very reluctant to cash any of their stock holdings. This is often because they do not want to cut off what little income they are receiving. Or, they are worried that they will need the capital later in life if they end up in a high priced nursing home. Or, they are worried about the tax bill they might face for selling the security. As a result they continue receiving the meager income and forget about the tax problem waiting to happen.

When they die they are of course deemed to have disposed of all of their assets at fair market value immediately preceding their demise. As a result the taxman often gets in excess of half of the investment in various taxes. If they are unfortunate enough to die late in the calendar year when they already have most of their annual income, the capital gains from their deemed disposition at death is added to their year's income. This coupled with any taxes due on their IRA, or other tax deferred plans, if there is no surviving spouse the taxes may well be over fifty percent for many estates. Add to that, probate fees, executor fees etc., etc. and the heirs are not left with much from those securities.

If they want to retain all of their capital for fear of running out of capital later in life, then it may be better to do it with a Term Deposit. At the time of death the only inclusion for income on the Terminal Tax Return is the accrued interest for the current year. In other words, no capital gain. I have found that sitting on a large unrealized gain is often poor estate planning for a client. There are of course other ways to deal with the problem, such as gifting, or life insurance, but for many older people this may not be available.

I usually like to set up new portfolios on systematic withdrawal plans (SWP) with an automatic withdrawal starting three to six months after the investment is started and paying quarterly, by direct deposit into the clients personal bank account. If it is a larger portfolio, I set up annual withdrawals with each fund paying out on a different month each year so there is regular monthly income. I usually use a different amount for each fund to make it easier to identify a missing deposit. So fund number one will have a withdrawal of $875.00 per quarter starting January 15, fund number two $880.00 per quarter starting on February 15, etc. I usually aim for an average of 7 to 8 percent per annum per fund. I like to use funds that have a long-term performance in excess of that figure so that on average we are not depleting capital. Most fund companies have a minimum of $15,000. to set up a SWP but I usually arrange my portfolios in $25,000 or, $50,000 increments, depending on the size of the total portfolio.

Even if the client does not need an income level of 7 or 8 percent from their taxable portfolio, I still like to arrange for it. I find that it is a good planning tool, to give the client a little more income than they need. For one, there is no transaction cost, or commission to the withdrawal. Even on funds purchased on a declining sales charge there is a ten percent free withdrawal allowed. This gives the client additional funds to invest once, or twice per year. I find that they seldom account for major capital expenses such as buying a new car. Having the extra cash flow helps to build up a reserve for such an event, while avoiding ill timed lump sum withdrawals.

One of the frustrations of advising someone about securities is that there is never a good time in their minds to sell. When an investment fund, or other security is doing well, the client never wants to sell the winning investment. When it is doing poorly they say they can't afford to sell it now at a loss. The result is that they never want to sell anything, when perhaps they should. So by them having a little extra cash flow, we can re-invest the surplus into the portfolio once, or twice per year and achieve the rebalancing we need in the portfolio, without stressing the client, or causing a tax problem due to a large disposition. We find this to be a stress free method of rebalancing and continuing to add diversification to the client's portfolio.
If a person buys an investment for $10,000.00 and it grows by twenty percent to $12,000.00 they naturally assume that if they sell the investment they would pay tax on the two thousand dollar profit and that is correct. But, only if they sell the full investment. This thinking is fostered by the mentality that when buying a stock and it subsequently raises in value to double, a common investment technique is to sell half of the holding and then “Ride for Free”. However, the correct tax treatment is quite different. If they sell $1,000. of the investment, only twenty per cent of the proceeds received are taxable (1,000.* 20% = 200. taxable). Almost all advisors are aware of this, but perhaps do not promote this advantage enough to clients. Most clients will think that because they made a two thousand profit that the first two thousand out of the investment is taxable. With the SWP the client thinks you are a genius. He has $1,000.00 in his pocket and only has to show $200. on his tax return.

When selling part of an Identical Property such as mutual fund units, or shares the tax is applied only to the difference between the average cost per share and the proceeds of sale per share. In other words if the client is drawing from a fund that has grown by ten percent that year he will pay tax only on ten percent of their SWP withdrawal. This is a very simple example. But to the client they have one hundred dollars of income and only ten dollars of it is taxable. The client's first reaction is that there must be something wrong. Or, how long has this been going on? But, that is what makes it such a wonder. I wrote a more in depth article on this topic about Identical Properties. You can get a copy of it on our web site. So the next time your client is inquiring about income from their portfolio, tell them about the “Ninth Wonder of the World”.

About the Author
Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian Association of Financial Planners for British Columbia, a former Director of the Canadian Association of Financial Planners. He has spoken across Canada on financial planning matters and has taught courses for the Chartered Financial Consultants & Certified Financial Planners degrees. He is the founder of Money Minders Software which produces financial planning software.