Be Tax Smart
For more on these and other important investment considerations, speak to a Financial Advisor.
Knowing what your options are, how they fit with your needs and what their tax consequences may be, is part of the discussion and Value of their Advice.
An investment’s total return is typically a combination of earned income and capital appreciation. A mutual fund will pay out a distribution to the investors in the fund, because the taxes payable in the investors’ hands are likely less than if the mutual fund itself had to pay taxes on the earned income and capital growth.
If the investor holds that fund in a registered plan (such as an RRSP, RESP or TFSA), then the distributions are reinvested and taxes are deferred or sheltered.
However, if the investment isn’t held inside a registered plan, declared distributions are taxable in the year earned (whether they be reinvested or paid as cash). For these non-registered holdings (sometimes called ‘cash accounts’), the investor needs to consider that:
- It can increase their overall taxes payable – regardless of whether the distribution is reinvested or received in cash
- The tax paid reduces the amount available to continue to grow (see tax-sheltered vs. non-tax-sheltered chart)
- Any market setback would be felt more, because the investment hasn’t grown as much as it would have if it was tax-sheltered
Not All Forms of Investment Income are Taxed the Same
Depending on the structure of the mutual fund, declared distributions can consist of: interest, dividends, capital gains, return of capital and/or foreign income. Foreign income is treated like interest and subject to the highest level of taxation. The mutual fund company will send you a tax receipt indicating how much of each to report.
Here are four different sources of distributions from a mutual fund, each paying $1,000. While they all amount to same cash flow they all have very different tax implications, which then affects the value of a portfolio.
This information is provided as a general source of information and should not be considered personal investment or tax advice. Investors should consult with their financial and tax advisors before making any investment- or tax-planning decisions.
Interest: fully taxable with a 40% marginal tax rate; $1,000 in interest will return $600 after tax.
Dividends: (assuming the individual is taxed in Ontario and the dividend is an eligible dividend for tax purposes) a $1,000 dividend gets grossed up by 38% in 2015 to make $1,380. Then the assumed 40% marginal tax is applied to give taxes of $552 (40% × $1,380). The $552 in taxes are reduced by the provincial and federal tax credit of 10% (including surtax) and 15.02%, respectively (10% × $1,380 + 15.02% × $1,380), which creates a tax credit of $345. This amount is subtracted by the taxes otherwise payable to give $207 tax payable ($552 – $345). Therefore, a $1,000 Canadian dividend would provide an after-tax value of $793.
Return of Capital: The returned capital amount is not taxable in the year received, but reduces the adjusted cost base of the investment, which generally results in a larger capital gain when the investment is sold, hence taxes are effectively deferred.
Capital Gains: Have preferential tax treatment where only 50% of the gain is taxable. Only 50% of a $1,000 capital gain is taxable, which means that only $500 would be subject to the 40% marginal tax. $500 × 40% = $200 taxes payable, therefore a $1,000 capital gain would result in an $800 after-tax return.
Taxation when you sell a mutual fund
First, if you’re selling a registered investment, the notes below don’t apply. To find out what happens with registered plans, visit Tax-Smart Registered Plans.
Whenever you choose to sell a non-registered investment, whether to switch it to another investment or cash it out, you will be taxed on any realized capital gain. A realized gain or “capital gain” is the profit that results from selling an asset that has a value greater than the adjusted cost base (ACB). While a capital gain has preferential tax treatment compared to other earnings, it still incurs a tax bite.
Capital Loss versus Non-capital Losses
To reduce the taxes payable on any realized capital gains, an investor can see if they have the opportunity to also realize a capital loss (when you sell an investment at a market price that is lower than its ACB). The amount of the capital loss can be subtracted from the amount of capital gain, and only 50% of such net capital gain is taxable.
Non-capital losses are different. They may incur from self-employment, a property or a business when expenses exceed income. A corporation (including a mutual fund corporation that houses corporate class versions of mutual funds) can carry non-capital losses for an extended period beyond the tax year incurred and apply those losses against subsequent year’s income. For more information on how long you can carry forward a non-capital loss, visit Canada Revenue Agency.
DID YOU KNOW
Year-end tax planning strategies:
In those years when you sell a non-registered investment and have a capital gain, speak to your financial advisor about the different ways you might be able to minimize the tax payable. You may be able to reduce the net payable if you can offset the capital gain with a capital loss, even if the loss originates from a previous year.
Canadian Dividend Tax Credit
Dividends declared by a Canadian corporation are eligible for the Dividend Tax Credit, which helps to reduce the actual tax payable. It is important to remember that foreign dividends do not qualify for this Tax Credit.
DID YOU KNOW
You should make sure you get both the federal and provincial tax credits.
There is a set formula for grossing up the dividend amount earned – both the federal and provincial governments grant their own dividend tax credit, equal to a percentage of this grossed up amount.
Get the cash flow you need from mutual fund distributions