If you have non-registered investments in your portfolio, you’re probably concerned about minimizing your taxable income within them. Here are some of the key factors that can affect an investment fund’s tax efficiency.
1. Type of income:
As you know, income can be generated in the form of interest, Canadian dividends, capital gains or foreign income. If the fund’s income is mainly interest and/or foreign income, it will be 100 per cent taxable to you in the year the fund earns it. If you have a fund that earns primarily Canadian dividend income, you have special tax rates for dividends paid from a taxable Canadian corporation which are somewhere between 62 to 75 per cent taxable. Capital gains today are the most tax efficient form of income. Now, you’ll only pay tax on half of your gains.
2. Unrealized gains:
Because of the way in which investment funds distribute income, you may be paying tax on income that you didn’t earn. Be aware of “pregnant” funds (or funds that haven’t distributed their income to the unit holders for some time). You could buy into a fund with large amount of unrealized gains that will be triggered at some point, and taxable to the investors who own at the time, but may not have owned when the fund grew these gains. The lower the unrealized gains at the time of purchase, the better off you are.
3. Asset turnover:
Asset turnover refers to how often the fund manager sells securities within the fund. Lower asset turnover will help you save on taxes. That’s because you’re responsible for the taxes on each taxable transaction the fund manager makes within the fund. However, low turnover can lead to a build-up of unrealized gains.
The amount of cash held in a fund could affect the tax efficiency of a fund in two ways. The challenge is because cash earns interest, the income is 100 per cent taxable. However higher levels would be available to pay redeeming investors, which lowers the amount of assets the fund manager has to sell to pay out an investor. Less to sell, means less potential of triggering capital gains. So cash has good and bad attributes.
5. Management style:
A growth management style often leads to higher turnover. A value style often reduces the turnover rate but can lead to more unrealized gains. In addition to these factors, you should consider which investments to hold in your registered investments. For example, you may want to hold some of your interest-earning, high-turnover funds as registered investments so that you are not liable for tax on their income in the year in which they earn it. You can defer it in your RRSP (Registered Retirement Savings Plan) and RRIF (Registered Retirement Income Fund) or have no tax in your TFSA (Tax Free Savings Account). Ask your financial security and investment representative to help you understand some of the changes you can do to reduce the overall tax on your portfolio.
Paul is a Certified Financial Planner (CFP) licensed by the Financial Planners Standards Council; Financial and Estate Plans are provided under that license.
The information contained in this website is intended to provide general guidelines only. The application and impact of the law can vary widely from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisers for advice concerning specific matters before making a decision.
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J. Paul Wilson,CFP®, ChFC®
Certified Financial Planner
27 Blue Thistle Road Halifax, Nova Scotia, B3S 1M3