Nobody likes to pay taxes. So you’re probably on the look-out for ways to reduce the tax bite. As it happens, there are a few investments that can ease the tax load when used properly in non-registered accounts. We show how three of them can be put to effective use: Corporate class mutual funds, T-series mutual funds and flow-through shares.
Still, we need to remember “these are all niche investments” and work well only in specific situations, says Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management.
Corporate Class Mutual Funds
Effective at year-end, the federal government plans to end the most prominent tax advantage of corporate class funds—the ability to switch from one fund to another within the same corporate class family without triggering immediate capital gains. But while that has a big impact, the remaining tax advantages can still make corporate class funds worthwhile.
To understand how that remaining advantage works, first realize that mutual funds essentially distribute income they receive back to the investors in those funds (after offsetting some of the potential income with fund expenses), so that income is generally taxed in the hands of investors rather than the fund itself. Where corporate-class funds have an advantage over conventional funds is that they’re able to pool capital gains, capital losses and expenses among funds in the same family to minimize taxable distributions. That can allow you to defer some of the tax until you sell the funds.
The magnitude of this continuing tax deferral advantage can be substantial in some cases, but varies widely. Using data from Morningstar.ca, I found the tax deferral advantage for the corporate class version of different funds varied from negligible to about 2.5 percentage points per year. In my view, corporate class funds with good tax reduction track records relative to their conventional counterparts offer the most potential, but understand there are no guarantees that tax advantages will be sustained.
T-Series Mutual Funds
T-series mutual funds can be useful when you reach retirement and want steady monthly withdrawals from mutual funds in a non-registered account at an annual rate of 5%, 6% or even 8%. The tax advantage of T-series is because most or all of the set distributions is expected in the form of return of capital, which isn’t taxable (but does reduce your adjusted cost base, or ACB). Withdrawals from the conventional version of the same fund is liable to come more in the form of taxable capital gains, resulting in greater immediate tax. Thus the T-series fund may allow you to defer some taxable capital gains until you sell your fund holdings.
T-series funds can be particularly useful if you need steady cash withdrawals but hold conventional mutual funds with large accumulated paper gains (that is, securities held within the funds have large unrealized capital gains). In that case, you may pay lots of capital gains tax on your withdrawals. But you can switch from the conventional version to a T-series version of the same fund without triggering a tax event, explains John Natale, assistant vice-president retirement and estate planning at Manulife. (That is possible only when switching between different versions of funds that are otherwise essentially the same.) Then going forward, you can take your withdrawals from the T-series version primarily through tax-friendly return of capital.
Flow-through shares are special offerings for shares in Canadian oil and gas, mining and renewable energy companies. You can invest directly in companies or through limited partnerships and mutual funds. Generally, you get to deduct the full amount of the investment from your income, then whatever proceeds you get selling the investments comes fully in the form of taxable capital gains. These investments are most appropriate for investors in high tax brackets, who have access to specialized experts who thoroughly understand these risky resource plays and who can tolerate plenty of risk. “I wouldn’t want anybody to buy without understanding the amount could go to zero,” says Golombek.
In the right circumstances, corporate class mutual funds, T-series mutual funds and flow-through shares can add a tax benefit to a fundamentally sound non-registered investment. But a tax angle won’t turn a bad investment into a good one. “The performance of the fund itself is the most important thing,” says Myron Knodel, director tax and estate at Investors Group. “The tax implications are secondary.”
Notes: (1) When investing in non-registered accounts. (2) Until Dec. 31, 2016, corporate class shares can also avoid triggering immediate taxable capital gains when switching funds within the same corporate class family. (3) Generally you can switch from the conventional version of the fund to the T-series version of the same fund without triggering a tax event. If a conventional fund doesn’t have much unrealized capital gains, or you expect to be in a high tax bracket when you sell the remaining fund holdings, then setting up a Systematic Withdrawal Plan (SWP) for a conventional fund might be a good alternative. (4) Generally the set withdrawal rates apply to the net asset value at the end of the previous year. A high withdrawal rate like 8% stands a strong chance of outpacing fund returns and so tends to diminish fund balances, in which case the 8% withdrawal rate would be applied to a diminishing balance. You also should monitor the adjusted cost base (ACB). Return of capital withdrawals lower the ACB. In some situations, the ACB could eventually go to zero, after which all withdrawals would be in the form of taxable capital gains. If the ACB gets close to zero, often it is a good idea to stop withdrawals to avoid triggering taxable capital gains, if you can afford to do so. (5) Several studies have shown that, on average, investors in flow-through shares would have been better off just investing in the corresponding resource stock market indexes, even after accounting for the sizable tax advantage of the flow-through shares. One such study is Rates of Return on Flow-Through Shares: Investors and Governments Beware by Vijay Jog, University of Calgary School of Public Policy research paper, February 2016.