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Three Key Tax Strategies for Mutual Fund Investors

by Wayne Cheveldayoff, 2003-06-07

When it comes to tax strategies, most individual investors think of RRSPs or RESPs and rightly so, since they are great ways to defer taxes as you build your investment portfolio. But if your planning ends there and your non-registered investment money is going into mutual funds without much further thought, you may be missing out on three important tax strategies that can be applied to mutual fund holdings.

It is important to remember that mutual funds held directly (outside a registered plan) are subject to the same tax rules as other investments: (a) interest is fully taxed at the same rate as salary income; (b) dividends are taxed at a somewhat lower preferred rate; and (c) only half of capital gains are included as income and taxed at the highest rate.

In practical terms, for an investor facing a 46% marginal tax rate on regular income, interest would be taxed at 46%, dividends at about 35% and capital gains at 23%.

Mutual funds are taxed at all three rates, depending on how much of the return is accounted for by interest, dividends and capital gains.

An important tax strategy, therefore, is to choose tax-efficient mutual funds--that is, those that have a favourable balance between historic rate of return and taxes owing on that return.

A recent study of the after-tax returns of equity mutual funds found that some top-ranked mutual funds (on the basis of simple rate of return) did not score high when tax efficiency was considered, while other funds scoring lower on a published rate-of-return basis placed at the top of the after-tax rankings.

The after-tax return of each mutual fund is not published in Canada in the same way as rate of return information. After-tax returns are required to be published in the United States, but not yet in Canada. Individual investors wanting after-tax rankings, therefore, will need the assistance of an investment advisor who keeps track of this information.

Another important tax strategy is to avoid making investments in mutual funds near the end of the year. This is because, unlike investing in a stock or bond, the trading gains, dividends and interest income of a mutual fund for the entire year are attributed to those holding units at the end of the year. (This, of course, does not matter when the mutual fund is held in a registered account such as an RRSP.)

Many investors, especially in the years when the stock market was rising sharply, unfortunately experienced a high tax bill for mutual funds bought outside RRSPs in the latter part of the year without the corresponding gains to show for it. The only way to avoid getting hit with such tax bills is to avoid investing near the end of the year.

A third strategy would be of interest to people with both a mortgage and non-registered investments in stocks, bonds or mutual funds and is based on the long-standing tax principle that the interest cost of any money borrowed to invest is tax-deductible.

Since there are special rules attached to this principle, the strategy is best carried out with the help of a tax accountant. However, it can make sense, if done correctly, to sell the mutual funds to raise cash to pay down the mortgage, and then borrow again to make new investments. The interest on this second borrowing would be tax deductible. (Note that to make this work, the mutual funds that are sold cannot be repurchased for at least 30 days and there has to be a clear paper trail.)

The Certified General Accounts of Ontario make reference to this strategy in their CGA Ontario Personal Tax Planning Guide, which can be accessed at

One additional point on mutual funds to keep in mind is that they are exceptionally tax efficient as an annual source of cash in retirement years. The initial withdrawals, up to the adjusted cost base, are tax-free since these are regarded as the return of principal. Pensioners can therefore make withdrawals, at least to some extent, without triggering the claw-backs associated with government pension payments if total income is pushed over a certain level.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at

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©2003 Wayne Cheveldayoff