Of mutual funds and taxes

One of the more over-looked aspects of mutual funds, and glossed over in the recent flight into money market mutual funds, is tax implications. As the below link discusses, the mutual fund industry in Canada has lobbied hard to prevent full disclosure of tax implications which may be detrimental to you and I. If nothing else, the morale of this post is seek tax advice from your accountant and understand the effect of taxes on mutual funds. As per usual, this is information only and not advice.

First a primer on taxes and mutual funds (this is specific only to Canada). Mutual funds are what are called “flow through” tax vehicles. This means whatever interest, dividends, return on capital or capital gains the mutual fund makes in a year flow through to you and you pay taxes on this profit either as cash in your account or in the form of reinvested units (i.e. the mutual fund does not file a tax return).

Interest income is generally the most inefficient type of income to receive since it is taxed at your marginal tax rate. Dividends in Canada are taxed on a byzantine formula only an accountant could love but the tax rate ends up being up to 30% depending on income bracket. Only 50% of your capital gains is taxed at your marginal tax rate. Every year the mutual fund company will send you a tax slip indicating how much to claim for interest income, dividends or capital gains.

Sounds simple at this point right? Here is the kicker though (this does not apply if you hold mutual funds in RSP’s). Mutual funds make distributions at different times of the year- monthly, quarterly or annually. Let’s call this a distribution period.  An investor is taxed for the distribution period even if they did not hold onto the mutual fund for the entire distribution period. Therefore, a mutual fund investor may be taxed on gains they did not earn.

Here’s a real life example. On September 29, 2008, the Dow Jones Industrial Average (a snapshot of big companies in the U.S.) declined 6.98%- the largest one day drop in history. Assume a nervous investor moved his entire portfolio from equity based mutual funds to a money market fund which makes distributions at the end of every month at noon that same day (assume for simplicity, the sale and purchase could occur on the same day). Under Canadian tax law that investor has now incurred tax on interest earned for the entire month of September even if he only held onto the units for 1 full day and, thus, only earned interest for one day.

Let me say this again- you may only earn interest, dividend or capital gains for the period of time you were invested in a mutual fund but you are taxed for the entire distribution period even if were not a unit-holder the entire time. In other words, you may have to pay taxes on a return you didn’t earn!

What are the logical implications?

1. If you still want to invest in mutual funds after reading this, be aware of the distribution periods. Does the fund pay monthly, quarterly or annually?
2. If you are seek shelter in money market funds, since most pay out distributions monthly, you are better off investing earlier in the month than later.
3. Many equity based mutual funds pay their distributions at the end of each calendar year. Thus, it may not be prudent to invest a large number of units later in the year in these types of mutual funds.

Now, the taxman cometh and the taxman takenth. The mutual fund industry may have a plausible excuse for this tax quirk BUT here are aspects of this that really smell.

1. This is not a material disclosure in most mutual fund offering documents (this is probably a failing of both the industry and the regulators)
2. Unlike the U.S., in Canada, mutual fund returns are stated as pre-tax returns and not after-tax returns. This artificially inflates the return on investment on a mutual fund not to mention the structural tax issues discussed above.

I gave ample credit to Ken Kivenko’s article on mutual funds and after-tax returns. Any mistakes in this post are mine. Morningstar as usual is also a good reference. Finally, Michael James has an interesting post on the new rules concerning mutual fund disclosures to investors.