Decoding tax bill for year-end pay-outs

National Post

2005-12-03



The start of December means D-day for mutual fund investors is fast
approaching. That's right -- you may soon be receiving a distribution of income
or capital gains. Many funds have a Dec. 15 year-end, so they'll be paying out
annual distributions sometime between then and Dec. 31.

Investors who hold funds outside a registered retirement savings plan or
retirement income fund might wonder why they have to pay tax on distributions
even though they haven't sold anything. Distributions are actually a sign the
fund has made money through income earned or capital gains realized -- at least
in the long term (more on that later).

If mutual fund trusts didn't distribute all their income and capital gains
each year, it would be taxed inside the trusts at the highest marginal tax rate.
Because few fund investors are actually in the top tax bracket (which kicks in
at about $116,000 in 2005), by having the income and gains flow through directly
to investors, the investors pay tax at their own, generally lower, tax rates.

That's enough to justify income distributions -- because if investors held
the underlying stocks or bonds, they'd pay tax on the dividends or interest
directly. But this reasoning is less satisfactory when it comes to capital gains
distributions. After all, if you didn't sell your fund, why should you have to
pay capital gains tax?

Keep in mind owning an equity fund isn't the same as owning a single stock. A
fund is a basket of securities. When a portfolio manager sells a position at a
profit during the year, a capital gain is realized. The same would be true if
investors held the individual stocks.

That said, the system isn't perfect, and the possibility exists for an
investor to receive a distribution from a fund that has declined in value since
it was purchased. This can occur, for example, when a fund's portfolio manager
disposes of securities during the year that result in net capital gains (after
deducting any capital losses). If the fund held those appreciating securities
for several years, and sold them in 2005, the capital gains realized in the
current year must be distributed to investors at year-end. Investors who bought
into that fund this year may receive capital gains distributions in respect of
the fund's 2005 realized gains -- despite the fact they may not have been
invested during the period in which the underlying securities appreciated. This
is referred to as "pre-paying tax on someone else's gains."

Mutual fund managers use a complicated formula in the Income Tax Act -- the
capital gains refund mechanism -- to try to reduce year-end gains distributions.
But the formula isn't perfect and can result in capital gains distributions to
investors who may not have experienced those gains.

While you may be tempted to switch out of a fund to avoid a distribution, you
need to compare the tax cost of the fund with the current fair market value to
determine whether you might actually be triggering a bigger tax liability than
you would have incurred if you'd received the distribution.

Want to know what your fund is distributing? A survey of the major fund
companies conducted earlier this week found that most have already released
distribution estimates for their December year-end funds.

Next week: Should you avoid buying funds in December? Myth v. reality.