Are you prepared for ‘tax information slip shock’?

2016 was a great year for most Canadian stock funds. So you may receive some shocking tax information slips near the end of February. And now, it’s too late to do anything but find the money and pay the taxes.

At this time of year, you’ll soon start to receive various tax information slips. And many mutual-fund investors may get a shock when they receive information slips from their fund companies.

After all, in calendar year 2016, the average Canadian equity fund gained 17 per cent in value. So your fund manager might have felt it appropriate to sell some winners in 2016. If so, you could end up with a nasty income-tax liability. And that may turn out to be the case even though your fund might not have performed relatively well last year.

The simplest way to think of your mutual fund is as a partnership in a portfolio of investments. In most cases, that’s exactly what it is.
Technically, mutual funds don’t pay dividends. Rather, they distribute to unit holders all interest, dividends and realized capital gains received by the fund each year.

Everything that happens in the fund will be taxed to you according to your share of ownership. The fund simply passes on the cash and your pro-rata income-tax consequences. So when your manager sells a long-term holding for a large gain (possibly accrued over several years), the gain becomes taxable as a capital gain in the year of the sale, even though the fund reported the gain month by month as it happened.

Conversely, if your manager held a large number of investments that lost value during 2016, these will have dragged down the performance of the fund during the year.

Now you see it; now you don’t

The result can easily be a fund that lost value in 2016, yet whose unit holders face alarming income tax liabilities. Further, if you’ve had your distributions automatically reinvested in the fund, you’ve simply made a new investment with the money. Most funds state in their prospectuses that unless you specifically request otherwise, they will automatically reinvest all distributions.

Of course, every fund’s management expenses are tax deductible. Most funds realize enough gains to pay these expenses. So the taxable distribution you receive comes after these expenses have been paid.

But administrators simply divide any further cash receipts pro-rata among a fund’s unit holders. You’ll receive forms showing your straight income, dividend income and capital gains or losses. What’s more, the Canada Revenue Agency (CRA) will also receive copies of these forms, and expect you to declare the income.

When you look at a fund’s compound annual growth rate over any number of years, the figure assumes full reinvestment of distributions. To see your investment grow at the rate quoted by your fund, you’ll have to find the money elsewhere with which to pay your income tax. Otherwise, you’ll have to take cash from your investment by redeeming your units.

Sometimes stocks and registered plans go together

The tax consequences of mutual-fund investing discussed above do not apply to investments held inside registered accounts, such as RRSPs, TFSAs and RRIFs. And we encourage you to make the maximum use of these plans, even if it involves buying equities inside them.

Some advisors, of course, caution that you never put equities inside a registered plan such as an RRSP. After all, you lose the preferential tax treatment of dividends and capital gains if you do. Instead, they insist you should keep interest-bearing investments in your registered plan, as these securities possess no special tax benefit features.

Such advisors forget that registered plans are the total portfolio for many investors. We don’t think you should alter your asset mix as a result. If you’ve decided to place 75 per cent of your portfolio in equities, and your whole portfolio is inside your plan, by all means invest in those equities inside your registered plan. After all, you invest in equities in the conviction that, over time, they will produce a higher return than will fixed-income securities. We’d rather see an eight-per-cent capital gain in an RRSP than two-per-cent interest, regardless of the tax features of these investments. Just be sure your equities fit with your needs.

 

This is an edited version of an article that was originally published for subscribers in the January 20, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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