Mutual funds are common investments but can often cause some tax confusion, particularly because investors don’t understand their real returns from these investments, after fees and taxes.
Here’s the year-end tax secret: In some cases, there are unintended results that can push investors into a higher tax bracket than expected at the end of a tax year and make quarterly instalment remittances, and often interest payments for under-remitting, necessary.
This is because mutual fund companies are required to distribute all interest, dividends, other income and net capital gains to their unit holders at least once every year at their fiscal year end. With the exception of any return of capital, these distributions are taxable.
Mutual fund trusts have a fiscal year end of December 31. Income for the full year will be distributed at the end of the calendar year. This is true, even if you invested late in the year. Therefore, investors may wish to hold over making the investment to the new year.
Mutual fund corporations, on the other hand, may choose a fiscal year other than the calendar year end. This means that income distributions could occur at any time in the year. Best to invest shortly after the distributions are made to avoid the tax. In addition, the cost of the units tends to decrease when the dispositions are made.
In addition, it’s noteworthy that rarely is this income received in cash. Rather, the income is used to buy more units in the fund and those reinvested amounts are added to the Adjusted Cost Base. This makes the reporting of sales or deemed dispositions of mutual funds a more difficult undertaking at tax time, because you will need to have kept track of your ACB. Most mutual fund companies can help you with this; however, it’s a good idea to track this on a spreadsheet to ensure the ultimate reporting of capital gains or losses on disposition is correct.
Don’t forget, switches between classes in a mutual fund become taxable after December 31, 2016. It is likely a good idea to review risk tolerance and investment objectives against this change in tax reporting rules, which will speed up the taxes that would otherwise be deferred until disposition. Consider whether the balancing of the investment portfolio before the year end can better manage outcomes.
Year-end tax planning involves a solid review of asset allocation strategies as well as net and taxable income levels to ensure that investment decisions in a non-registered account achieve the right results. This includes a review of marginal tax rates and potential clawbacks of tax credits or OAS. Speak to a DFA-Tax Services Specialist for assistance if required, before year end.