Beware the December fund trap

Most mutual funds that make annual distributions declare them in December. If you hold your funds in a non-registered account, these payments will be taxable, whether they are received as cash or additional units.

All mutual fund trusts must distribute any net realized capital gains, dividends, and interest income to unitholders at least once a year. The result can sometimes be an unpleasant surprise for investors.

For example, the Fidelity Canadian Asset Allocation Fund has lost slightly over 6% this year (to Nov. 18/02). However, holders of the fund’s “A” units are expected to receive a payment of about $0.15 a share, while the “F” units are projected to pay $0.35 each. When the distributions are made, the net asset value of the units will drop correspondingly.

This means that even though your fund lost money, Canada Customs and Revenue is going to present you with a tax bill. Many investors see this as adding insult to injury, but that’s the way the system works.

Some fund companies provide advance estimates of their year-end distributions to financial advisors for tax planning purposes, and Fidelity has been a leader in this regard. In a statent released Nov. 18, the company indicated that it doesn’t expect to make distributions on any of its equity funds this year. But they are forecasting payments on three balanced funds, ranging from $0.05 to $0.35 a unit. Distributions will be paid Dec. 20 to shareholders of record as of Dec. 19. If you own units in Fidelity’s Canadian Asset Allocation Fund, Canadian Balanced Fund, or Global Asset Allocation Fund, check with your financial advisor for details. Also ask your advisor about advance distribution information on any other funds you own. Be aware that not all companies provide this, however.

Special warning: if you are planning to buy new units in any mutual fund this month for a non-registered account, find out if a distribution is planned. If so, delay your purchase until after the distribution date. Otherwise, you will end up paying tax on part of your own capital.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides guidance on fund selection and portfolio building for investors.