How to take profits without paying tax

I know of people who had huge paper profits on their mutual fund investments, but refused to sell when the markets were high because they didn’t want to pay tax.In retrospect, it was a bad decision, especially when the gains were in science and technology funds. Understandable, perhaps, but bad.

We all want to minimize taxes, and good tax planning is an important part of every non-registered portfolio. So what’s the answer to this kind of dilemma?

For starters, you need to understand the rules. The government takes the position that a switch is the same as a sale. So even if you simply move your assets from one fund to another in the same group to crystallize the gain, you’re on the hook. Even though the capital gains inclusion rate has dropped to 50 percent, that still causes many people to hesitate before pulling the trigger, even if a switch or a sale makes sense.

Several fund companies have responded to this problem by creating “umbrella” funds. These are mega-funds that contain multiple classes of shares. Typically, under the umbrella you might expect to find a Canadian equity fund, at least one U.S. stock fund, a global fund, fixed-income fund and a money market fund. Usually, several more choices are offered, often including a variety of sector funds.

Although they function in much the same way as stand-alone mutual funds, the investment pools within these master funds are referred to as “classes” or, somewhat confusingly, “sector shares”. When you see either of these terms used, it indicates you are buying units in a portfolio that is actually part of an umbrella fund.

The advantage to the unitholder is that you can move your money around at will under the umbrella without triggering a taxable capital gain. So you can switch from, for example, a science and technology class to a fixed-income class and take your gains without attracting the attention of the tax people. You only incur a tax liability when you cash out of the umbrella fund entirely.

Often, the classes in an umbrella fund are simply a spin-off from a stand-alone parent fund, with the same manager, mandate, and much the same portfolio. However, the returns may vary because of slight differences in MER or the timing of purchases.

If there is a stand-alone option (which is not always the case) the umbrella fund version should not be used in a registered plan (RRSP, RRIF) because there is no tax advantage in doing so and returns tend to be slightly lower than those of the parent fund. But as a tax-planning tool, this type of fund can be very useful.

Adapted from Gordon Pape’s new book 6 Steps to $1 Million, published by Prentice Hall Canada.