Watch for tax pitfalls with mutual funds

We’re approaching that time of year when many mutual funds distribute the capital gains they’ve realized throughout the year to their unit holders. This event should serve as a reminder to you to give thought to tax planning when you invest in mutual funds.

Tax_Pitfall_with_Mutual_FundsWatch the funds outside your registered accounts. Otherwise, you may find yourself on the hook for taxes if you buy just prior to an end-of-the-year capital gains distribution. And the amount in tax you’ll have to pay can, on occasion, be startlingly high.

Most funds, of course, simply reinvest the cash from your distributions unless you specify otherwise. But you’re left with the income-tax consequences of that distribution.

Most, or even all, gains realized by your fund so far this year may already be reflected in the net asset value per unit if you buy its units now. But you’ll still have to pay taxes on the gains.

The distribution, since it’s cash leaving the fund, will reduce the value of your units. And the reinvestment of the distribution will give you more units. So when you ultimately redeem your investment, you’ll have a reduced capital gain to offset the tax you pay this year on someone else’s gain. But in the meantime, you will have, in effect, given the federal and provincial governments an interest-free loan.

Beware of investing late in the year

If you invested in a mutual fund early in the year, then you’ll reap the benefits of any capital gains the fund distributes. So at least you’ll pay tax on profits you made.

In general, then, you should avoid large mutual-fund purchases near the end of the year. Instead, defer large purchases until the beginning of the following year. Keep in mind, though, that if markets decline in the final months of this year, the buying opportunity provided by lower share prices may well outweigh the potentially negative tax consequences of large year-end purchases.

Remember too, when you sell a fund at a profit, you’ll also have an additional taxable capital gain on gains the fund has made but not yet distributed. Even if you simply switch from one fund to another within the same family of funds, you’ll trigger either a capital gain or a capital loss.

We advise against frequent fund switching. If you switch at the wrong time, you may lose money. If you do so at the right time, you’ll share the profits with the tax-collectors.

Of course, if you shelter your mutual funds in a registered account, you sidestep the tax consequences noted above. That doesn’t mean, however, there are no tax disadvantages of holding mutual funds inside registered accounts. For example, if your fund distributes dividends paid by Canadian companies, the dividend tax credit goes to waste.

This is an edited version of an article that was originally published for subscribers in the November 2, 2018, 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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