December tax trap

This is the time of year when I again remind our readers not to make any new mutual fund purchases for non-registered plans without checking first to see if any large distributions are planned in December. Failure to do this could lead to an unpleasant tax surprise.

Most equity funds pay capital gains distributions once a year, usually in December. If the managers have taken significant profits within the portfolio, these can sometimes be quite large. To illustrate, RBC O’Shaughnessy U.S. Growth Fund will pay out an estimated $1.75 per unit later this month. That’s 9 per cent of the recent NAV.

Suppose you bought new units for a non-registered portfolio between now and the distribution date. Here’s what would happen if you invested $10,000. You would pay about $19.50 per unit and receive approximately 512 units. Shortly thereafter, you’d receive credit for $896 (512 x $1.75) in the form of cash or new units. At the same time, the NAV of your 512 units would fall by the amount of the distribution, to $17.75. You are left with original units worth $9,088 plus a cheque or new units purchased with the payment. Either way, the amount is taxable.

The effective result that you end up paying tax on about $900 of your original capital.  Obviously, that’s not a position you want to be in so be extra careful with your fund shopping this month.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides advice on fund selection and strategies. For subscription information: