Mutual funds

Mutual funds and taxes

Mutual funds that are held inside an RRSP are tax sheltered. Only withdrawals from the RRSP itself are taxable. Surrenders or switches within an RRSP are not taxed. Funds that are not held within an RRSP are subject to tax on the gains that can come in three forms: capital gains, dividends, and interest.

Capital Gains: Taxes can be triggered for a couple of reasons. The first one is because you sold all or part of your units in a fund for more than you paid. The difference is called a capital gain and 50% of that gain has to be included in your taxable income for the current taxation year. Expenses such as sales charges and surrender charges can be deducted for tax purposes. The second reason that will trigger a capital gain is when the fund manager sells a holding in the fund for a profit. You will have to include your share of that profit for capital gains tax purposes.

Dividends: Dividends that are earned by investments held in your mutual fund are taxed in your hands. They are subject to the dividend tax credit, which means that the actual tax you pay is reduced by approximately one third.

Interest: Interest earned by holdings in your fund are reported to Revenue Canada and you have to include the amount in your taxable income.

You can minimize taxes if you sell only when you need to.: Remember that capital gains are triggered only when you "realize" them meaning that when you sell the holdings that have gone up in value. If you must sell try to hold off until the beginning of the next year. It means that the gain is not going to be reported until the end of that year and thus deferring the taxes you have to pay.

You can reduce taxes by being careful when you switch funds. Switching from one fund to another held by the same fund manager is popular because usually there is no charge and it allows you to adjust your portfolio to take changing circumstances into account. Revenue Canada treats switching from one fund to another as selling one fund and buying another. Consequently and gains in the fund that was "sold" will be subject to tax.

Avoid buying into a fund at year-end is our last tax saving tip.: Funds frequently distribute profits to unit holders on December 31. The net effect is that the Net Asset Value Per Share (NAVPS) is reduced accordingly thus reducing your unit values but leaving you with the tax liability for the full profit paid to you. Some funds distribute profits more frequently, which reduces the problem.