Don’t Get Caught in a Mutual Fund Tax Trap

Dec 23, 2019 | Marcia Zhou


Share

How to avoid mutual fund tax surprises.

The end of the year is often associated with savings, as consumers hunt for good deals from Black Friday through to Boxing Day. It is often said that “a penny saved is a penny earned,” and this holds true for reducing taxes associated with mutual fund investments. A solid tax strategy should be an integral part of prudent investing, so it is important to understand some of the most effective ways to reduce taxes associated with mutual funds.

Among the many popular tax-reducing strategies such as tax-loss-selling, deferral of capital gains, and tax shelters, strategic timing of mutual fund investments is a lesser-known approach that is also worth considering.

When you invest in a mutual fund during the year, you purchase the fund at its Net Asset Value (NAV), which includes any accumulated income and gains that have not yet been distributed. When the fund makes a distribution of these accumulated earnings, proceeds become fully taxable (if the investment is in a non-registered account).

How to accurately account for the investment returns of mutual funds

A common point of confusion for investors is the difference between book value and net investment amount.

Investors are accustomed to reviewing their monthly investment statements by comparing book value with market value. From this, they often arrive at a simple conclusion as to whether they are making a profit or loss. These numbers, however, can be deceiving.

Mutual funds are priced daily based on their Net Asset Value. Over the year, a mutual fund earns interest and dividend payments. It also incurs capital gains or losses stemming from its underlying investments. The fund’s NAV is increased by any income received by the fund and accumulates until its next distribution, thus increasing the fund’s unit price.

Mutual fund investors incur a tax liability whenever the fund makes a distribution. If the fund is set-up to reinvest earnings rather than distribute them, investors will come to hold additional units at a lower price-per-unit.

For example, imagine that you invest $100,000 in a mutual fund with a DRIP (Dividend Reinvested Plan) during the year, and then you receive a distribution of 3% at the end of the year. You would still hold the same fund with the unchanged initial investment of $100,000, but your year-end statement would display a book value of $103,000 as a result of the distribution. If the market value becomes $110,000, the return on your initial investment of $100,000 should be calculated as 10%, rather than 6.8%.

If you choose a plan for which dividends (or distributions) are reinvested, the book value of the fund in the monthly statement becomes over-stated. Book values are informative for tax purposes, but not for investment performance reviews.

How to avoid unpleasant tax slip surprises

Mutual fund investors should be aware of any distributions that have occurred throughout the year. If you own mutual funds in a non-registered account at year-end, any distributions received will be included in that year’s taxable income. 

We recommend some strategic tax planning before the purchase of any mutual funds near the end of the year. Many mutual fund companies provide estimates of current-year distributions from late November to December. Based on the potential percentage of year-end mutual fund distributions, investors should use the following three strategies to deal with large distributions:

  1. For new purchases, you could simply wait until after the distribution date to invest in the fund. This way, you would be purchasing the fund without any accumulated income and gains. Those who purchase just before the fund pays out distributions will experience an apparent loss, since the net asset value of the fund will be reduced by the amount of the distribution. This is similar to the relationship between dividends and ex-dividend dates, when the price of a stock is reduced by the amount of dividends paid.
  2. If you have already purchased the fund, consider selling it prior to the distribution date. Before selling, first consider the size of the potential distribution and the resulting tax liability. It is important to determine how much you would save, by comparing the tax amount saved by avoiding the receipt of this distribution, with the costs that a sale could trigger (such as redemption fees).
  3. If you are eager to immediately own a mutual fund with an impending distribution, consider purchasing it in a registered tax-deferral RRSP account or a tax-sheltered TFSA account.

When investors tactically harvest capital losses in non-registered accounts, unpleasant tax burdens can be minimized, leading to some extra savings (or a perhaps few more presents under the tree!).

Categories

Tax Investing