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Making the switch to mutual funds "Traditional GIC buyers are sometimes ready to buy any good mutual fund story without knowing what lies beneath." Low interest rates often prompt many people to purchase
mutual
funds - often for the first time. Traditional GIC
buyers are sometimes ready to buy any good mutual fund story without really
knowing the characteristics of the new investment. Mutual funds are capital investments rather than savings
products like GICs and if held outside an RRSP,
require more bookkeeping and tax reporting. There are two main tax influences on mutual funds held outside of RRSPs. The first is dependent on what is going on inside the fund itself. It is determined by the type of investments held by the fund manager and by trading actions taken with them. The second is dependent on actions taken by you, the owner of the fund. First, let's look at what happens inside the fund. How does the type of investment held in the fund affect you? Money market, mortgage and bond funds will generate interest income that will be distributed to you monthly or quarterly. The total amount will be taxable and reported to you annually on a T-3, even if you reinvest the distribution. Dividend funds will also distribute income regularly and produce a T-3, but this income will be more tax efficient because of the dividend tax credit. Funds that hold growth oriented stocks do not produce much income and therefore have little to distribute. Trading actions taken by the fund manager will also affect your tax situation. He or she will buy and sell investments within the fund and any net capital gains made will be distributed equally across all unit holders depending on the number of shares owned and will be reported on your T-3. Some managers are very active traders and may generate lots of taxable capital gains. Others use a "buy and hold" strategy which can produce growth for you through higher unit prices as the investments increase in value. These investments however, tend to generate fewer taxable capital gains because they are not trading as much. Secondly, let's look at how certain actions taken by you will also affect your tax liability. If you sell part or all of your mutual fund you will create a capital gain or loss, which is the difference between the market value of the units sold and their adjusted cost base (ACB). The ACB is the weighted average cost of your fund units and it changes each time a purchase is made or distribution reinvested. Make sure you learn how to calculate your ACB and keep track of your capital gains or losses because you will not receive a T-3 for them. Switching between funds will also trigger a capital
gain or loss on the fund switched out of, even if no funds are withdrawn.
Again, the gain or loss is determined by the difference between the market
value and the ACB at the time of the switch. There is also something called a "deemed disposition" which assumes, for tax purposes, that all capital investments are sold for their fair market value and triggers the built up capital gains or losses at that time. A deemed disposition will occur at death and the capital gains rules will apply if the assets are left to anyone other than a spouse. You will also have a deemed disposition if you change the registration on your mutual funds to anyone other than a spouse. For example, a deemed disposition would occur if you make them joint with your children for estate purposes. In summary, if you move from the simplicity of GICs to mutual funds, make sure you know what kind of taxable income the investments inside your mutual fund will generate and if the management style is "active" or "buy and hold". Also be aware of the tax implications of any actions on your part.
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