Two portfolios generating the same cash flow can produce very different taxable income. For retirees approaching Old Age Security (OAS) recovery thresholds, the structure of income may matter as much as the amount.
Retirement income planning has long focused on generating reliable cash flow. An equally important but sometimes less discussed consideration is how that income is classified for tax purposes, particularly for retirees approaching OAS recovery thresholds.
Because OAS is calculated using net income reported on a tax return rather than cash received, portfolios producing similar levels of income can lead to very different results.
When Cash Flow and Taxable Income Diverge
A simple comparison illustrates the point.
If a retiree receives $50,000 in eligible Canadian dividends, those dividends are grossed up by 38 percent. Roughly $69,000 is reflected as income for OAS calculations.
If that same $50,000 is realized as capital gains, only half is included in taxable income. The reported amount becomes $25,000.
The investor’s spending power may be similar in both scenarios, but the impact on OAS eligibility can be dramatically different. For retirees combining pensions, RRIF withdrawals, and taxable investments, these differences can accumulate quickly.
Moving Beyond Yield as the Only Metric
Canadian income portfolios have long leaned on dividend paying equities. Dividends remain valuable, but their tax treatment means they can increase reported income faster than many investors expect.
This has prompted more discussion around how different investment strategies generate and distribute income. Increasingly, attention is shifting toward the character of distributions, not just their size.
Covered call ETFs are one example worth understanding in this context. These strategies typically hold a portfolio of equities while writing call options on some or all of those holdings. The option premiums collected can generate additional income, which may be distributed to investors alongside dividends received from the underlying stocks.
Because distributions can include a combination of dividends, option premiums, and portfolio gains, the resulting tax character may differ from traditional dividend focused portfolios. Depending on the strategy and market conditions, a larger portion of distributions may be characterized as capital gains vs eligible dividends, although the mix can vary from year to year and is never guaranteed.
Blending Income Sources in a Portfolio
One way to think about covered call strategies is as a complement to traditional dividend holdings rather than a replacement.
In practice, this might involve shifting a portion of a dividend position into a covered call ETF that writes options on the same stock or sector.
Instead of holding 100 percent of a position in a single dividend-paying stock such as Royal Bank of Canada, an advisor could allocate a portion of that exposure to a covered call ETF that writes options on the same company or on a broader basket of Canadian bank stocks.
The investor maintains exposure to the sector, but the income profile changes. Rather than relying primarily on dividend income, the portfolio may generate a combination of dividends and option premiums, which may be characterized differently for tax purposes depending on the strategy and annual distribution breakdown.
The objective is not to replace traditional dividend exposure, but to blend income sources so that the overall income stream can better align with a client’s broader planning objectives.
An Illustrative Income Equity Sleeve
Another way to look at the concept is to consider how different income strategies can work together within the income sleeve of a portfolio.
Illustrative Income Equity Allocation
Component |
Allocation |
Rationale |
|---|---|---|
Traditional dividend equities |
50–70% |
Maintains core dividend growth exposure and access to the dividend tax credit |
Covered call ETFs on broad or sector equities |
20–40% |
Introduces option-premium-driven income that may be less sensitive to market direction and may include capital gains depending on distribution characteristics |
Tactical or thematic income sources (i.e. REITs, preferred shares, private credit, etc) |
0–20% |
Provides diversification of income streams and exposure to different economic drivers |
This type of structure can help diversify not just asset exposure, but also income sources, which may provide additional flexibility when considering taxable income in retirement.
A Subtle but Important Consideration
As portfolios transition from accumulation to decumulation, the distinction between income received and income reported can become increasingly relevant for higher income retirees.
Covered call strategies represent one example of how portfolio income can be generated from multiple sources, which may influence the tax character of distributions. While distribution composition can vary from year to year and outcomes are never guaranteed, understanding how different strategies generate income can add another dimension to retirement income planning.
To learn more about covered call strategies and the Ninepoint HighShares ETFs speak with your Ninepoint representative or Financial Advisor, and download our whitepaper, The Advisor’s Guide to Covered Call ETFs in Canada.