September and October were the worst two months we’ve seen in the stock markets in a generation. Most people have suffered heavy losses in their portfolios. So how would you like to pay tax on those losses? You wouldn’t? Then you had better take a long, hard look at any mutual funds you own in non-registered accounts and prepare to make some tough decisions. Otherwise, you risk falling into an expensive tax trap.
Here’s the situation. From October 2002 to June 2003, the Toronto Stock Exchange went on a tear. From its 2002 low of 5,678 it climbed almost 9.500 points to 15,155 in early June of this year, an increase of 167 per cent. Then, as we know, the bottom fell out.
At that point, many mutual fund managers were holding stocks which had appreciated significantly in value. In many cases, those stocks were worth double, triple, even quadruple the price originally paid. When it became apparent the bull market was over, managers began selling to lock in gains and to raise cash.
When a fund disposes of a security, it is a taxable event and a capital gain or loss is triggered. At the end of each year, these are totalled and any net gains are distributed to investors. However, this doesn’t make you any richer because the net asset value of your units drops accordingly. It may look like a wash but from a tax perspective it’s anything but.
The distributions become taxable in the recipient’s hands, whether they are received in the form of cash or more units. A T3 reporting slip is issued and the income must be declared when the next return is filed.
Here’s where it gets dicey. It is possible, even probable, that the fund making the distributions will end 2008 with a big loss. But you could be forced to pay tax as well because of the profitable sales made by the manager over the period. So you end up losing money and being assessed tax on top of it!
If any fund you own is expected to make a large taxable distribution, the only way to avoid taking a tax hit is to sell your units before that happens. Fund companies do not pro rate the tax liability among all unit holders during the year; only those who own units at the time of the distribution are affected.
Of course, selling your units will trigger a personal capital gain or loss so you should assess the implications of that before acting. But if you acquired the units earlier this year, before the crash, you’ll probably be farther ahead by selling as your holdings will likely be worth less now than when you bought them. If you’ve owned them for a long time, you’ll need to look at the pros and cons of divesting since you’ll likely have a capital gain, despite the recent setback.
Some companies (Fidelity is an example) give advance notice of expected distributions, usually during November. Most funds (but not all) have a Dec. 15 year-end and distributions are usually made on the following Friday. If you are going to sell, you must do so before the record date for the distribution. Ask your advisor about this, or contact the company directly.
Remember, this only applies to units in non-registered accounts. Any mutual funds held in RRSPs, RRIFs, etc. are tax-sheltered and you don’t need to worry about them.
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, click here.