TAX EFFICIENCY
The mutual fund advertisements shout higher and higher yields, often trying to sell you on short-term performance. While high performance is obviously important, it is the volatility of the longer-term performance that tells a more useful story.
And for non-registered investments, how much of that growth is reportable as income each year is perhaps even more important, since it is the after-tax performance that ultimately counts. “Tax Efficiency” refers to the proportion of an investment’s annual growth that is not subject to annual taxation. It also incorporates the effective tax rates for various types of income, to produce a measure of how much growth you actually keep.
For instance, a bank account that produces interest income is only 50% efficient, assuming a 50% marginal tax rate, since every cent of income is reportable each year, and that income receives no preferential tax treatment.
Conversely assuming a personal 50% tax rate, funds that generate dividend income, rather than interest or capital gains income, will tend to be more tax efficient, since dividends are taxed at 36% and capital gains 39%.
In general, a “buy and hold” strategy will improve the tax efficiency of any fund, since a significant portion of the fund growth is in the form of unrealized capital gains – i.e., paper profits that would only be reportable if the fund manager sold the underlying securities.
Please go to the Segregated Fund Form to continue.
TAX FRIENDLY INCOME
The most effective and tax-friendly way to generate a steady investment income is to set up a segregated fund withdrawal plan. It’s one of the best features of segregated funds. These withdrawal plans, set up for investments outside RRSP’s, create significant tax benefits.
The most obvious attraction is that you have complete control over how much income you get, when you get it and for how long it lasts. By contrast, the far better known annuity, involves a trade of your capital in return for a guaranteed income amount.
Let’s say you invest $100,000 in an equity or equity index fund at $10 per unit which grows by 10 percent in year one and that is the amount you plan to withdraw. It would appear that a $10,000 capital gain will be realized the sale of the units, but this is not the case.
The actual realized gain is the difference between the purchase price of $10 and the current market value of $11 or $1 per unit. You need to redeem 909 units to generate $10,000. Thus 909 x $1 or $909 is your gain. Under the current tax law, 50% of that gain is taxable. That’s $455. Assuming you have to pay the average top marginal tax rate of 50%, your total tax exposure for income of $10,000 per year is a mere $228.
Please go to the Segregated Fund Form to continue.
TAX LOSSES
It is widely known that segfunds offer advantages over mutual funds in terms of maturity and mortality guarantees and creditor protection.
But, another feature that is less publicized is a tax advantage: if a segregated fund loses capital in a given year, the unitholders can claim the capital loss on their taxes and offset any capital gains made on other investments. Mutual fund investors cannot do this.
The reason behind this is that while taxation rules permit segfunds to allocate out gains and losses, mutual fund companies do not have the ability to allocate distribute gains or losses. Distributing and allocating are two different things.
With distribution, you must physically distribute the dollars out and you can’t physically distribute a loss. If a person invests $1000 in a segfund and it’s worth $900 by the end of the year, he or she can receive a T3 form showing negative $100. This can be used to offset a capital gain on another investment.
In the same situation, a mutual fund holder could not declare the loss
unless he had already cashed it in.
Please go to the Segregated Fund Form to continue.