Calculate mutual fund income with caution.
It's easy to slip up when figuring out tax payable on income from non-registered mutual fund investments. Here's why.
While mutual funds are taxed in much the same manner as your other investments, some important differences exist. Understanding these differences makes it easier to cut the taxman's take.
When investing in an equity or other growth mutual fund, you buy units in the hope they'll rise in value. A sale usually triggers capital gain or loss. Tax is payable on half of any gain just as it is with stock or other capital investments.
Mutual funds are an easier way to invest than buying, tracking and selling individual securities. But the tax implications of a fund investment outside your RRSP can be quite complex.
Tax on mutual funds is triggered by two separate events. The first is an income distribution to unit holders. This income can be in the form of capital gains, capital gains dividends, dividends, foreign income, interest, other income, or a combination of these. All distributions are taxable, whether received in cash or reinvested in more units of the mutual fund. Most distributions, in fact, are paid in the form of new fund units as investors generally choose automatic reinvestment.
The second tax trigger is an actual sale. When you redeem or sell non-registered units, or transfer between funds (except within multi-class mutual fund corporations), you are taxed on any capital gain.
Not all types of fund income are taxed at the same rate. You pay the lowest rate on capital gains, followed by dividends from Canadian companies. Interest income and dividends from foreign companies offer no tax relief to investors. Interest income from a money market, bond, mortgage or balanced fund is similarly taxed at the full rate, just like your salary or pension.
Each year your mutual fund company will send you tax slips stating your income allocations from the fund during the year. Most mutual funds are structured as trusts, and they distribute a T3 slip that itemizes Canadian dividends, foreign income, capital gains and other income distributed to unit holders during the year or at year-end. You report these amounts separately on your tax return.
Some funds are set up as corporations. They distribute T5 slips that combine various forms of income (interest, Canadian dividends, and foreign dividends) into a single dividend amount. All this income is eligible for the dividend tax credit. Capital gains dividends are itemized as a separate distribution
It's very complicated to break down a fund's annual distribution into the various streams for tax purposes. Be thankful that the fund companies do this for you when they send out tax slips. But note that these tax slips do not report capital gains or losses realized on the sale of any mutual fund investment during the year.
So when selling a mutual fund, make sure fund distributions reinvested by buying new units are taken into account when calculating capital gains or losses. Some fund companies and brokers do provide a summary statement, but you may have to keep your own records of this. Otherwise, you could unknowingly subject yourself to double taxation.
All new units the fund company distributes to you throughout the year (quarterly, semi-annually, annually) contribute to the adjusted cost base (ACB) for your total holdings in that fund.
Your ACB equals the amount you paid initially (including any up-front sales commission or front-end load), plus the amount of reinvested distributions, plus the amount of any additional purchases. Then your capital gain (loss) equals proceeds from the sale (less any charges), minus your ACB.
Here's an example: You invest $10,000 (including any charges) in a mutual fund. You receive a $600 distribution that's reinvested at year-end. You later make an additional $5,000 purchase. Unit prices are different for each transaction.
|Transaction||Units||Unit Price||Adjusted Cost||Average Cost|
Later, you sell all of your 1,400 units for $18.00 each or a total of $25,200. Your calculation equals:
Proceeds from the sale $25,200
Minus Adjusted Cost Base $15,600
Capital Gain $ 9,600
Taxable Capital Gain @ 50% $ 4,800
If you sell only some of your units, calculate the ACB by multiplying the number of units sold by the average cost.
Here are 4 more tax-saving tips to keep in mind when buying and selling mutual funds:
- Avoid purchasing a mutual fund close to year-end. You may receive an unexpected capital gains distribution regardless of how many days you owned the fund. The capital gains distribution represents cumulative capital gains realized during the year, before you bought your units.
- Consider investing in multi-class mutual fund corporations. These umbrella corporations contain many different types of mutual fund, each with its own investment portfolio mandate. CRA allows investors to transfer investments among the share classes of a corporation without tax consequences. Consider investing in more "tax-efficient" mutual funds that disclose both before- and after-tax investment returns. Funds can have the same before-tax rate of return, but can have quite different after-tax rates of return, depending on the turnover (buying and selling) within the fund during the holding period and the classification of the gains.
- Before investing in mutual funds, talk to your tax and/or financial advisor if one of your goals is to reduce or defer tax on your investments to maximize their long-term growth.
If you would like a free consultation to find out how FBC can help you with your small business tax needs, call 1-855-378-3628, or email today.