Today’s entry is from another guest author – Ken Kivenko from CanadianFundWatch.com. Ken is an investor advocate and regularly provides good material to consider and discuss. He recently sent me this article by email I thought it would be worthwhile to share, with Ken’s permission…
It’s that time of year again.
Time to think about mutual fund income and capital gains distributions. Most actively managed funds are structured as open–ended mutual fund trusts. Mutual fund trusts are taxed at the highest tax rate for all forms of income earned. As a result, fund companies typically avoid paying this tax by distributing to investors the interest/dividend income and capital gains earned within the fund since the last distribution date, net of fees and expenses. This makes sense since unitholders may hold the fund in a RRSP or be in a low tax bracket. Unitholders thus pay income tax on these distributions at their marginal tax rate according to the type of income or capital gain earned.
The accumulated taxable capital gains distributions are unfortunately usually made in December sometimes leading to “unitholder shock ” if a large purchase of a fund in a non-registered account was made toward the end of the taxation year but before the distribution. This may not be too serious for low turnover income and dividend funds but check the distribution history before investing. Some funds may be able to provide you an indication of expected distributions near calendar year end. Additionally, if an investor doesn’t have the cash he or she may have to sell some investments thus reducing ongoing income. That can be especially disturbing if he/she paid a sales commission on purchase or must pay a DSC charge for early redemption. If however he/she has net capital losses for the year there is no tax problem.
Several commentators actually suggest avoiding purchasing a mutual fund after October to avoid this effective prepayment of income tax. This might be appropriate but only done after considering the investment merits of deferring the purchase. The inability of individuals to time capital gains/losses is one of the important disadvantages of mutual fund investing.
Here’s how the convoluted system works:
Suppose John D. invests $100,000 in a Dividend and Income fund at $10.00 per unit to purchase 10,000 units for a non-registered account (e.g. not a RRSP). The mutual fund has been, and intends to, continue paying $0.035 per unit per month. i.e. 4.2% annual yield. John will be delighted to receive a monthly cheque for $350 much of it tax advantaged as dividend or capital gain income. But unknown to unsuspecting John, the fund has realized considerable capital gains during the year. On December 31, the fund declares a distribution of $1.00 per unit taxable as a capital gain in the current tax year. John must declare a capital gain of $10,000($1.00 x 1000) and that will result in an income tax liability of about $1800-$2500 depending on his tax bracket and province of residence.
Assuming John reinvests the distribution in units of the fund it will cause no change in his gross monthly income. Each fund unit will now have a NAV of $9.00 as cash has left the fund. Gross monthly distributions remain the same but there being more units, the distribution per unit will decline accordingly. John will now own his original 10,000 units at a cost of $10 each and will have purchased $10,000 worth of new units at the reduced price of $9.00 per unit for a total of 1,111.11 units .The Adjusted Cost Base for income tax purposes will be $9.90/unit ($110,000 spent to purchase 1,111.11 units) so that he or his estate will realize that much smaller a capital gain upon disposition.
The bottom line is that John must pay income taxes now in exchange for reduced capital gain and tax liability downstream. In effect he is providing an interest-free loan to the government for the term from April of the following year until he liquidates the holding.
Be tax Smart.
Ken Kivenko P.Eng.