Mutual Fund Tax Management
Much like any other investment product, whenever you buy and sell a mutual fund there are potential tax implications that should be considered. As investors, we typically spend most of our time trying to ensure that we have the right investments in our portfolio, scrutinizing our decisions based on an investment’s rate of return and risk characteristics. However, it’s not always this simple – and what we earn, isn’t necessarily what we get.
We often don’t think about our investments in the context of taxes, but understanding after-tax returns leads us to becoming better investors, and can be a major influence on whether or not we reach our investment goals.
When it comes to mutual fund investments, taxes that investors are ‘on the hook’ for generally come from 2 different sources:
- Taxes on the distributions an investor receives from a mutual fund
- Taxes on a disposition due to selling a mutual fund outright or switching from one mutual fund to another
What you need to know about mutual fund distributions
Whether we rely on the income from investments to manage regular day-to-day expenses or if it’s simply because we prefer the benefits of income investing for long-term growth, it’s evident that income investing has become an important part of our portfolios. Depending on your investment goals, there are generally 2 options when a mutual fund makes a distribution:
- Receive the distribution in the form of a cash payment
- Reinvest the distribution back into the fund by purchasing additional units
A mutual fund can be set up as a trust or a corporation. The main difference between an investment in a trust and a corporation is in how the entity and your investment in the entity are taxed. This is generally more important if you are investing outside of a registered plan.
A mutual fund that is a trust will, each year, distribute enough of its net income and net realized capital gains so that the fund will not be subject to normal income tax. The fund will flow its taxable income through to investors in the form of distributions. Investors are generally taxed on this income as if they earned it directly.
A mutual fund that is a corporation will generally flow its Canadian source dividend income through to investors in the form of ordinary dividends and its net realized capital gains through to investors in the form of capital gains dividends. The fund will pay tax on other types of income (such as interest or foreign source dividends) if that income is more than its deductible expenses and investment losses.