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One of the first things an investor should decide before committing any funds is whether they are investing for growth or income. Ideally when investing for growth the products selected should increase in value over time but not generate a lot of current tax liability. If you are working and trying to save money for later use wouldn’t you rather avoid any taxes on the money you are attempting to save until such time as you actually spend it? This is especially important if you will be in a lower tax bracket when that time comes. On the other hand if you are investing for income, wouldn’t you prefer to keep as much of your earnings as possible in your pocket and not have to shell out a large part to the government when you file your tax return? Let’s look at both situations separately and see what can be done to satisfy these questions. Growth Investors Growth investors are more inclined to use equity investments such as stock based mutual funds because the general rule of thumb is that equities on average provide better growth opportunities in the long term. (Some of you may wish to challenge this statement if your portfolio has suffered through the stock market carnage of the past few years: thus the emphasis is on “long term”) Tax liabilities for the mutual fund investor arise from two sources. The first is from the distributions received from the funds as result of interest ,dividends and/or capital gains earned on the investments within the fund which are passed through proportionately to all unit holders. The second source is from any capital gains made when the investor sells some or all of a fund. Growth investors may do a lot of buying and selling as they follow market trends and attempt to maximize their growth potential by constantly changing their holdings. As a result they may incur a lot of capital gains tax along the way if their investments are successful. Even the “buy and hold” type of investor may want to make a portfolio adjustment at some time but may think otherwise if they have a large built up capital gain and therefore a large potential tax liability if they make a change to their investments. For the growth investor an ideal investment therefore would be one that eliminates yearly taxable distributions and allows the flexibility to buy and sell without incurring capital gains liabilities. With mutual funds the elimination of taxable distributions is a difficult task because investors have no control over them. Research into a fund’s management style is helpful because a manager who is an active trader is more likely to generate yearly distributions while a “buy and hold” manager may not produce one for several years. The latter style may seem more tax efficient but this is not really true if several years of no distributions are followed by a huge distribution in a single year. The best approach is to become familiar with a fund manager’s investment style and be constantly aware of the status of any unrealized capital gains within a fund to help you decide which funds to own for your non registered portfolio. The larger the unrealized capital gains the greater the potential tax liability if the fund manager sells some of his/her holdings. From a taxation perspective the ideal fund combines a “buy and hold” manager in a fund that has low unrealized capital gains. Most mutual funds make their yearly distributions in December and in many cases will provide an estimate of the potential size of the distribution if you ask. If you know a large distribution is coming you can avoid it by simply selling the fund before the record date. Of course by doing so you may trigger a significant capital gain if your adjusted cost base is a lot lower than the market value of the fund. This is the proverbial “from the frying pan into the fire” dilemma whereby trying to avoid a distribution may cause more harm than receiving it. Now just before you think the prior discussion was pointless, there is a way to sell out of a fund without incurring a capital gain. This can be done by ensuring that your non registered purchases are done in a capital class structure as outlined below. Many mutual fund families now offer what is commonly
referred to as a capital class structure. This is a separate group of
funds each of which is considered to be a separate class of shares of
a single corporation and thus exempt from tax when money is moved from
one fund to another within the capital class structure. All capital gains
are deferred until such time as money is actually withdrawn from the funds
and therefore investors can control their own tax situation by the amount
of their redemptions. This exemption therefore solves the problem of triggering
capital gains when moving from one fund to another to avoid a distribution.
The tax conscious investor can therefore combine the tax friendliness
of a capital class structure with timely switches out of any funds that
have pending large distributions to effectively defer their capital gains
liabilities to a later date. Investors who are looking for a steady stream of income have often used various combinations of equity, bond, balanced and dividend funds. The last three types of funds generally produce a regular flow of income from their underlying investments. There are two common methods of receiving income from mutual funds. The first method simply involves taking the monthly or quarterly distributions provided directly by the fund (normally available with bond or dividend funds and some balanced funds). This is beneficial in some ways because there is no actual redemptions of invested units and no record keeping is required as the fund company simply issues a T3 or T5 for the total amount of the yearly distributions. The T-slip will include any interest income, dividend income and capital gains passed through by the distributions. The problem with this method however is that the distribution amounts can fluctuate and may be insufficient depending on the individual's cash requirements. Furthermore the full amount of the distribution is taxable. A second common method to receive income is to set up a what is referred to as a systematic withdrawal plan from chosen funds and receive a specific amount each month to meet income requirements. This method however requires the redemption of invested units to meet the systematic payments. Since units are sold each time the investor must keep track of the capital gain or loss incurred for each unit sale in order to report the net yearly gain or loss on their income tax return. Only the net capital gain on all the units sold each year is taxable. This may not be that high in some years however the funds may also pay regular distributions which will be taxable as well. The combined effect can be expensive in years where there is a large distribution. Income investors therefore need to find the most tax efficient method of earning a steady income. A third alternative to those noted above is to use what some fund companies call their "T" class of funds. These funds pay out a set monthly amount per unit of funds held (ie $.08/share). The actual amount per share to be paid out is decided by the fund manager and is based on the realistic expectation of the fund's future performance. The payments are treated as a distribution and therefore no units have to be redeemed. The good news is that a portion of the actual amount received will exceed the income earned by the fund and therefore is treated as a "return of capital". What's good about this is that a return of capital may be a significant portion of the income received and it is not taxable. Investors can therefore receive a stream of income with part of it untaxed which is a bonus for those with high incomes who are over 65 as the untaxed portion will not impact on any income tested benefits such as Old Age Security . How can paying out more than the fund earns be good? Remember that an investment can still grow in value even if it is not generating any income. Therefore as long as the growth of the fund's investments equals or exceeds the amount disbursed to its unit holders, the fund will maintain its value. The not so good news is that the return of capital amounts while not taxable are treated as a tax deferral and are deducted from the cost base of the fund, meaning that they will increase the capital gain when the fund is eventually sold. (if the fund is held for many years the deductions may reduce the cost base to zero so that the return of capital amount then becomes taxable in the year received) The other negative is that in a bad market the fund value may not grow enough to offset the amounts distributed and the manager may decide to reduce the payout per share to compensate, thus reducing the amount of monthly cash flow. I feel that the third alternative is the best choice
overall for someone who wants a predictable, tax efficient income. Market
declines will affect fund values no matter which option is chosen. Also,
the deferral of the capital gain is something that can be managed by strategically
selling the fund when it best suits the investor. These type of funds
are definitely worth a look. Fidelity Investments Inc, one of the worlds largest investment fund managers, have introduced into Canada a tax sensitive calculator called the Fidelity T-SWP™ calculator. This interactive tool allows you to run a head-to-head comparison against a traditional SWP, highlighting Fidelity T-SWP’s increased tax-efficiency and higher monthly cash flow. You can quickly and easily calculate the tax advantage that Fidelity T-SWP can offer investor clients by tailoring the information to meet their unique cash-flow needs. Fidelity T-SWP™ enables you to receive a high level of tax-efficient monthly cash flow, even in this low interest rate environment, while benefiting from an investment in one of three leading Fidelity balanced funds. Try out the Fidelity T-SWP calculator today, and see for yourself the tax benefit that Fidelity T-SWP can offer your clients. * * *
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