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Yes, you can find tax happiness with mutual funds

by | Mar 26, 2015 | SELF-PUBLISHED

But the search for tax efficiency can get complicated

High net worth investors are keen on tax efficiency in their investments. Understandably so, since taxes have a huge impact on investment returns. Mutual funds are sometimes seen as least tax efficient, because of their distributions to unitholders, which can be taxed as income, dividends, or capital gains – sometimes all three. However, some funds use what’s called the Capital Gain Refund Mechanism to reduce or eliminate the tax hit on unitholders. How does this work, and are there any other tax-efficient strategies available?

TFSAs, RRSPs the best tax shelters

The best way to shelter mutual fund gains from tax is through a Tax-Free Savings Account (TFSA). Fund distributions, investment income, dividends, and capital gains within a TFSA are not subject to tax, either while inside the plan or on withdrawal. The only real drawback for TFSAs is the relatively low annual contribution limit, currently $5,500. However, high net worth investors will use this, and any previous contribution room, fairly quickly.

A Registered Retirement Saving Plan (RRSP) has a higher contribution limit, and unused contribution room can add up pretty quickly. Contributions are eligible for a tax deduction. Investments in the plan grow on a tax-deferred basis, and are subject to tax at your top marginal rate only at the time of withdrawal (usually at retirement, when your top marginal tax rate is expected to be lower than in your peak earning years).

In addition, the use of tax benefits such as the use of tax losses to offset gains and the dividend tax credit are lost within registered plans.

Tax-advantaged funds

If you’ve maximized both TFSA and RRSP contributions, then you might want to consider adding some tax-advantaged mutual funds to your investment mix. These are funds specially structured to minimize capital gains tax.

The first step is to determine if a tax-advantaged mutual fund fits into your investment objectives and risk tolerance. In a typical actively-managed mutual fund, a portfolio manager will buy and sell securities in an attempt to make profits for unitholders. Capital gains and losses are attributed back to the investor, and taxes are paid.

Tax-advantaged mutual funds, on the other hand, are geared to limit capital gain distributions through a low turnover strategy. When portfolio managers deploy this strategy, they buy and hold securities to help minimize tax. By not continually buying and selling holdings, the manager is not triggering capital gains that are attributable back to the investor.

Tax expertise needed

The manager must also be able to successfully manage cash inflow and outflows, carry forward capital and operating losses, crystallize gains, and manage the Capital Gain Refund Mechanism (CGRM). The CGRM is a complex tax provision in the Income Tax Act that allows an eligible fund to offset some of its realized capital gains in a given tax year, so that unitholders will be spared the tax hit (remember, half of capital gains must be taken into income and taxed at your highest marginal rate).

The CGRM is used mostly by buy-and-hold funds with low portfolio turnover. The danger here, however, is that if a long market slump triggers an unusually high number of redemptions, the fund may have to sell long-standing positions, triggering large capital gains for unitholders. To determine if a fund uses the CGRM, ask your advisor or check with the fund.

Getting advice on tax efficiency

A few other tax-efficient options to look at are index funds, corporate class funds, and tax-efficient systematic withdrawal plans. Tax efficiency should be a consideration in every financial plan, as taxes have a major impact on your investment return. But the interplay of tax-advantaged registered plans, tax-efficient funds, and investments (such as dividend-paying stocks) can get complicated.

To develop a truly tax-efficient long-term investment plan, consult a qualified financial advisor, who is knowledgeable about the tax impact of various investment choices, and who can apply tax-efficiency to an overall investment plan that meets your risk tolerance level and financial objectives.

© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

© 2023 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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