Can my ETF pay me $3,000 a month in retirement?

Q. I have $500,000 that I would like to invest in the Horizons S&P/TSX 60 Index ETF (HXT). I like the fact that this ETF does not make distributions, so there is no income tax to be paid before the shares are sold. I want to use the account to pay me a “return of capital” of $3,000 per month. Is that possible? If not, is there another way to do it? – Luc B.

The Horizons S&P/TSX 60 Index ETF (HXT) is what’s called a “swap-based ETF,” and it works differently from a traditional index fund. The ETF’s benchmark includes 60 large Canadian companies, but HXT does not actually hold the stocks directly. Instead, it enters an arrangement with a “counterparty” (a bank) that promises to deliver to the ETF the same total return as the index.

The main appeal of swap-based ETFs is they don’t pay dividends in cash: instead, they increase in price by an amount equal to the dividend. That means you won’t pay any taxes until you eventually sell your shares of the ETF. At that point, any price increases will be taxable as capital gains, which are often taxed at a lower rate than dividends. This makes swap-based ETFs appealing for investors with large non-registered accounts.

But while swap-based ETFs have many advantages, Luc, they are not designed to generate monthly cash flow the way you’ve envisioned. You mention that you want to receive a “return of capital,” which suggests you’re expecting your $3,000 monthly cash flow to be tax-deferred. (When a fund pays return of capital, this is not taxable in the year it is received. Instead, it causes the fund’s adjusted cost base to decline, which will lead to larger capital gains when the shares are eventually sold.) But for you, it won’t be because HXT cannot be used to generate return of capital.

RELATED: Understanding capital gains distributions

If your goal is to take $3,000 per month from your holding in HXT, your only option would be to sell some shares every time you need cash. On every sale you will realize a capital gain or loss, depending how the price of the fund has changed since you purchased it. At the end of the year, you’ll need to report the net gain or loss and pay the appropriate amount of tax. So if your goal is to defer taxes rather than paying them every year, this is not the way to do it.

If you want a simple solution for generating tax-efficient cash flow, you might consider one of the many monthly income funds offered by the big banks. These are diversified mutual funds, usually contain a mix of bonds and dividend-paying stocks, that pay out a fixed amount each month. In most cases, this payout is more than the interest and dividends generated by the investments, and the excess is considered return of capital.

For example, a monthly income fund might target a 7% annual distribution, and this might be made up of 1% interest, 2% in dividends and a top-up of 4% in return of capital. On a $500,000 investment, a 7% distribution would be just shy of $3,000 a month.

Just be aware that generous distributions like this may not be sustainable. They may be appropriate if you are planning to draw down the fund over a finite period, but a 7% withdrawal may result in the depletion of your capital over the longer term. Note also that many monthly income mutual funds carry high fees that can eat up a big chunk of the interest and dividends.

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