Retirement Mistake No.21: Just Buying a Mutual Fund When You Can Go Corporate Class
Posted In: Retirement Planning for Entrepreneurs

If you are investing your hard-earned after-tax money in a mutual fund, I have one question for you. Is the mutual fund or segregated fund taxable on an annual basis; and if so, do you know how much tax you might pay this year on it?

Taxable and Tax-class Mutual Fund Investors

Until recently, mutual fund investors did not have a choice, they had to pay the tax. However, some investment companies now separate mutual fund investors as taxable and tax-class. Mutual fund companies know investors have different investment needs. Therefore have created two types, one called “mutual fund trusts” and the second called “corporate-class” or “tax-class” investments. The corporate-class investors have the luxury of  deferring taxes until they sell the fund or portfolio or start to take out income. They also have a huge advantage in that they can switch to another mutual fund in the same class without triggering any tax. For example, if I switch from US Equity Class fund to Canadian Dividend Class fund, there is no tax. I am not stuck on switching my investments and diversifying because of tax.

Investors in regular mutual funds are always concerned about their after-tax annual returns, since some or all of the income generated may be taxable in the year received. Even worse, some investors purchase a mutual fund in November and receive taxable distributions from the fund in December as if they held it for a full year, potentially adding a lot of tax, yikes!

The other problem that can arise is if the fund manager has to decide on keeping or selling a security that has a large capital gain or one that has no capital gain. That is the same for the investor as the switching problem. If you go from an equity fund to a money market fund there may be a taxable capital gain; but if you go from equity- to short-term class, there is no tax. This investment structure offers investors more flexibility for their non-registered money. The next time you talk to your advisor, ask whether your non-registered investment can be separated between mutual funds and tax-class funds.

Defer Tax, Save Money Every Year

If you could invest outside of  a RRSP and defer taxes, would you? Or, knowing that you could defer taxation on your investments until you decide to trigger the tax, would you? If you could turn interest income into capital gains income and keep the investment into bonds, would you?

If  you answered yes to any of  those questions, you need to learn about corporate-class mutual fund plan. They offer the ability to invest in a variety of  mutual funds and defer taxation until the investor decides to withdraw the money. There are two tax structures under which mutual funds are set up. Most are established as mutual fund trusts; the others as mutual fund corporations.

Investing in mutual fund corporations provides several benefits, usually without additional cost. These benefits include tax deferral, tax-free switching, capital gains taxes on income, and options for diversification.

I had a friend that wanted to switch out of a fund that she held for more than ten years. The management of the fund changed, and she wasn’t comfortable with the new direction. She had two options. She could either pay the capital gain of more than $30,000 and switch to a new investment. Or, she could leave it as is because she had such a large tax bill. It became a tax decision more than an investment decision.

By establishing funds inside a corporate share structure, you are eliminating this problem down the road, and you can make sound financial decisions regardless of the tax.

A second example is a market downturn. If an investor wants to switch to cash or to a short-term fund because of volatility, he or she can switch without any tax consequences.

A financial planning tip: I strongly recommend you examine the funds you own, figure out the capital gains and losses on switching these funds around today, then imagine if they were all in corporate share structures, which would eliminate the taxes upon switching. Several companies now offer corporate structures and most financial professionals usually only recommend corporate share funds for clients. As one investor put it to me, why would you not have all of your investments in corporate-class?

A Different Kind of  Mutual Fund

mutual fund

One of  the last things we need these days is another mutual fund. When I started in the financial business some sixteen years ago, there were approximately 400 different mutual funds. Now there are more than 5,000 in Canada alone.

There is another type that is not exactly a mutual fund. Let me explain. There are two tax structures under which we can set up mutual funds. Most are mutual fund trusts. The second and newest type of structure is a mutual fund corporation. A fund company issues several classes of shares and calls them “funds,” with each class of shares representing a different mutual fund. As an investor, you are permitted to switch among the share classes without triggering capital gains on those you previously owned. As long as your investment remains within the corporate share structure, capital gains earned on a specific class of share are deferred. In layman’s terms, if you buy an equity fund under a corporate structure and switch it for another equity or short-term fund under the corporate structure, there is no tax or capital gain triggered, unlike a typical mutual fund.

If you don’t own corporate funds outside your RRSP, now would be a good time to switch into them–examine the tax consequences first.

How Mr. Jones Kept Up with the Neighbors

Mr. Jones dropped by to discuss how he could protect his income from the market and Revenue Canada (now CRA).

Last year, Mr. Jones was uncomfortable holding stocks and mutual funds and decided to sell at a loss, triggering a capital loss. His argument to me was that at age 70 he might never be able to use up his capital losses because he could not see himself investing in the stock market for quite a while.

“It’s fine for my neighbors since they’re in their fifties and have a long time to recover from market drops, so they will eventually reap the rewards of triggering capital gains. Since I put my money into fixed income (GICs and bond funds) that only pay interest, I can’t take the tax advantages that my neighbors can afford,” said Mr. Jones in a frustrated tone.

What to do

I said to him, “What if I could invest your money in a bond fund (which you are comfortable holding since it has less risk than an equity fund) and generate capital gains that you can claim against your capital losses? How much would you pay for such a bond fund? Imagine getting 4% to 5% interest next year and not paying tax on it? Well, guess what? A couple of  mutual fund companies in Canada have developed bond funds that generate capital gains inside their corporate-class tax funds. This idea only started last year so most investors haven’t heard of  it. But as more and more Mr. Joneses switch to safer investments, safer doesn’t have to mean more tax.”

Mr. Jones decided to switch some of  his bond fund holdings into corporate-class bond funds. They are essentially the same type of  bonds inside the bond fund he was holding. Thus, he was able to recapture capital losses triggered in the last year. When Mr. Jones sells his tax-class bond fund, chances are it will be tax-free.

The next day I had a visit from his neighbors. They asked me how they can keep up with the Joneses.

The best way to prepare for life is to begin to live. – Elbert Hubbard

The whole of  life is but a moment of  time. It is our duty, therefore to use it, not to misuse it. – Plutarch


Published with permission from Grant Hicks

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