Monthly Cheques or Return of Capital: What Big Bank Income Funds Actually Pay
Two income funds can each deposit $500 into a Charlottetown retiree's account every month and still leave that retiree in very different places ten years later. The cheque shows what the fund pays. It does not show what the fund earned. The gap between those two numbers is often filled with return of capital, which means some of your own money coming back to you. The T3 slip shows the split each year, and most people file it without reading it.
Here is how that plays out in a choice I see often: a big bank monthly income fund with a fixed payout, or a lower-cost fund or ETF mix that pays only what it earns.
The same starting point
All figures below are illustrative only. They are not current yields or fees for any real product.
$100,000 invested in a non-registered account
Both portfolios hold similar bonds and dividend stocks that earn 4% a year before fees
Option A: a bank income fund with a 1.5% annual fee that pays a fixed 6% a year, or $500 a month
Option B: a lower-cost mix with a 0.5% fee that pays out whatever it earns
What the arithmetic shows
In Option A, the fund earns 4%, keeps 1.5% as fees, and is left with 2.5%, or $2,500. It pays out $6,000. The other $3,500 comes out of your principal. If markets are flat, the account starts year two at about $96,500, and that smaller balance has to produce the next $6,000.
In Option B, the fund earns 4% and keeps 0.5%, so it pays about $3,500, or roughly $292 a month. The cheque varies with what the holdings produce, and the $100,000 stays invested.
The fee difference is the part you can calculate exactly. In this example it is one percentage point, or $1,000 a year on $100,000, every year, whatever markets do.
The payout difference is less of a gap than it looks. An Option B investor who needs $500 a month can sell about $2,500 of units over the year. That is also money from their own capital. The only real difference is that they decide when to sell instead of the fund deciding for them.
Where tax changes the picture
Return of capital is not taxed when you receive it. It lowers your adjusted cost base instead. In Option A, roughly $3,500 a year of tax is deferred, and when you sell, your gain is bigger by that amount. Under current rules, 50% of capital gains is included in income. That deferral is a real benefit, especially in a year when your other income is high, but you will pay the tax eventually.
Selling units in Option B gets similar treatment. Only the gain on the units you sell is taxable. So the tax advantage of Option A is small and mostly about timing.
Three situations change this:
Inside a TFSA, none of this matters for tax. The fee and the erosion of your principal are the only issues left.
Inside a corporation, return of capital is not investment income, so it does not count toward the $50,000 passive income threshold. Above that threshold, the small business deduction drops by $5 for every dollar of passive income. For a PEI business owner close to that line, the type of payout matters.
With borrowed money, such as a Smith Manoeuvre™ setup, interest is deductible when the borrowing is used to earn investment income. If you spend return of capital on personal expenses, you can shrink the deductible portion of the loan. You need to plan the tracing before the first distribution arrives.
The case each side can honestly make
Option A buys you a cheque that does not change, no decisions about when to sell during a downturn, and one statement from your own branch. For a retiree whose CPP and OAS fall short of monthly costs, that predictability has value. It just cannot be measured in dollars.
Option B buys you lower costs, a cheque that shows what your money is actually earning, and more of your principal still working for you. It also asks more of you: you have to sell units on a schedule, including in years when prices are down.
Neither option protects your principal. Unlike a GIC, neither is covered by CDIC, and both lose value when interest rates rise.
Which one fits
Option A suits someone who values a fixed cheque above all, holds the fund in a TFSA or RRIF, and understands that part of each payment is their own money. Option B suits someone comfortable setting up automatic sales who wants to keep the fee difference. If you hold investments in a corporation, have a borrowing strategy, or are drawing faster than your portfolio earns, look at the T3 split and your adjusted cost base before you decide.
Two income funds can each deposit $500 into a Charlottetown retiree's account every month and still leave that retiree in very different places ten years later. The cheque shows what the fund pays. It does not show what the fund earned. The gap between those two numbers is often filled with return of capital, which means some of your own money coming back to you. The T3 slip shows the split each year, and most people file it without reading it.
Here is how that plays out in a choice I see often: a big bank monthly income fund with a fixed payout, or a lower-cost fund or ETF mix that pays only what it earns.
The same starting point
All figures below are illustrative only. They are not current yields or fees for any real product.
What the arithmetic shows
In Option A, the fund earns 4%, keeps 1.5% as fees, and is left with 2.5%, or $2,500. It pays out $6,000. The other $3,500 comes out of your principal. If markets are flat, the account starts year two at about $96,500, and that smaller balance has to produce the next $6,000.
In Option B, the fund earns 4% and keeps 0.5%, so it pays about $3,500, or roughly $292 a month. The cheque varies with what the holdings produce, and the $100,000 stays invested.
The fee difference is the part you can calculate exactly. In this example it is one percentage point, or $1,000 a year on $100,000, every year, whatever markets do.
The payout difference is less of a gap than it looks. An Option B investor who needs $500 a month can sell about $2,500 of units over the year. That is also money from their own capital. The only real difference is that they decide when to sell instead of the fund deciding for them.
Where tax changes the picture
Return of capital is not taxed when you receive it. It lowers your adjusted cost base instead. In Option A, roughly $3,500 a year of tax is deferred, and when you sell, your gain is bigger by that amount. Under current rules, 50% of capital gains is included in income. That deferral is a real benefit, especially in a year when your other income is high, but you will pay the tax eventually.
Selling units in Option B gets similar treatment. Only the gain on the units you sell is taxable. So the tax advantage of Option A is small and mostly about timing.
Three situations change this:
The case each side can honestly make
Option A buys you a cheque that does not change, no decisions about when to sell during a downturn, and one statement from your own branch. For a retiree whose CPP and OAS fall short of monthly costs, that predictability has value. It just cannot be measured in dollars.
Option B buys you lower costs, a cheque that shows what your money is actually earning, and more of your principal still working for you. It also asks more of you: you have to sell units on a schedule, including in years when prices are down.
Neither option protects your principal. Unlike a GIC, neither is covered by CDIC, and both lose value when interest rates rise.
Which one fits
Option A suits someone who values a fixed cheque above all, holds the fund in a TFSA or RRIF, and understands that part of each payment is their own money. Option B suits someone comfortable setting up automatic sales who wants to keep the fee difference. If you hold investments in a corporation, have a borrowing strategy, or are drawing faster than your portfolio earns, look at the T3 split and your adjusted cost base before you decide.
Sources
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