Who wants to give away their monies to government agencies? Raise your hand. Obviously there should be no hands going up right about now. The cliché is that you work hard for your money. You don’t want to give that money away, needlessly.

As Canadians we can pay some very high tax rates on income and we pay considerable taxes when we purchase items by way of sales taxes and surtaxes. We likely all pay our fair share like ‘good Canadians’ but let’s not go overboard on the charity here. Let’s limit the amount that we hand over, all in above-the-board legal fashion of course.

Year end tax planning for investors

Year End Tax Traps for Mutual Funds and ETFs

As we are now into late October we’ll start with the year-end tax trap for mutual funds and ETFs and perhaps even individual stocks. I had touched on this in my recent Mutual Funds 101 post.

A mutual fund will usually and mostly pay a distribution once a year in late December. That distribution represents the income in the fund from bonds and stock dividends. If you hold these funds in a taxable (non-registered) environment that income is taxable. There are no concerns if you hold that fund in an RRSP, TFSA or RRIF as the income is not taxable.

Here’s the tricky thing with a mutual fund distribution; it represents the bond income and dividend income that has already arrived in the fund throughout the year. There is no value added or created on distribution day. The mutual fund price will drop in equal proportions to the income delivered. That said the full amount of the distribution is taxable.

And here’s the trap. It you buy a mutual fund in November and the fund delivers a distribution in December (representing the full year’s fund income) you will pay tax on the full year’s income even though you’ve only been in the fund a few weeks.

We want to limit our taxes paid and we certainly do not want to pay taxes on monies we did not receive. This tax trap can exist in ETFs as well, given that ETFs can pay distributions on an annual, semi-annual, quarterly or monthly basis. Of course, the shorter the period the less effect of the trap of paying tax on income that you did not receive.

Unexpected Capital Gains

Thanks to fee-for-service financial planner Jason Heath who explains how we can also see capital gains show up in the year end tax trap.

Mutual fund and ETF trusts distribute their income – interest, dividends and realized capital gains – to investors. They may not literally distribute the income in the form of cash, as it may be reinvested in the fund, but the income is considered distributed for personal income tax purposes. That’s why on a T3 tax slip that reports trust income you see a box for capital gains. This isn’t capital gains you had from selling your fund, but rather, it’s for capital gains realized by the fund itself on underlying investments it sold during the year that get allocated to you. 

 

The risk of an unexpected capital gains distribution is more significant for an actively managed mutual fund or ETF that may be selling a position it has owned for years or that has appreciated significantly. A passive ETF will typically just be rebalancing over the course of a year and small tweaks are less likely to result in a large year-end capital gains distribution. You may be able to check with a mutual fund or ETF company towards year-end to see if they can provide an estimated capital gains distribution for the year. 

So when should we ignore the tax trap?

If you are doing the prudent thing and investing on a regular schedule or by way of an automatic investment plan – stay the course. Both Robb Engen and me will also give you a standing ovation. That consistency is a staple of wealth creation. You’ve made purchases throughout the year, you will benefit from the income that was delivered throughout the year. And if you’re considering making a smaller purchase there might be little by way of tax consequences.

We will pay attention to the tax trap when we are making large year-end purchases that will create a meaningful tax event. That said, there’s more than the income consideration for an investor. In an environment when stocks and funds have been falling in price in considerable fashion, an investor might decide to take the tax hit to buy the stocks or funds as they ‘go on sale’. They might feel that there is great long term value. That is a personal decision, but make sure you do understand the tax consequences.

It may also be a time to sell your funds or stocks. It might be time to say ‘so long’ to your investments that are under water. Bye bye losers.

Tax-Loss Harvesting

On tax loss harvesting Jason offers …

Tax loss harvesting may be a suitable strategy. I say “may” because it depends. If you have non-registered investments that have declined in value from their purchase price, you may have a capital loss you can realize for tax purposes. If you have realized capital gains in the current year, or taxable capital gains in the previous 3 years, you can claim current year losses to offset them. You have to claim current year losses against current year gains and be in a net loss position for the year before you can carry any current year losses back to a previous year. And if you have net losses for the year that you don’t carry back, they can be carried forward indefinitely.

And Jason also warns against the situations where it might not make sense to sell your losers. After all, we are only pushing the eventual tax burden down the road.

Some people aim to minimize income or tax payable at all costs, but purposely realizing a loss when your income would have been pretty low anyway may provide little benefit if you expect your income to be much higher in the future. That capital loss that you may have to claim against current year capital gains may be better used in a future higher income year to offset capital gains in that year.

And as we head into November and December here are a few other year-end tax pointers courtesy of James Gauthier, the Chief Investment Officer at robo-advisor Justwealth. I will also expand on some of the topics that James offers for consideration.

Pension Tax Credit RRIF withdrawals ($2,000) for tax year need to be withdrawn (if applicable). These apply to those who are 65 years old and above.

Ensure you have all desired retirement income settled from all sources for current calendar year. Ensure that trades settle a few days before year-end. The trades go by full settlement not trade entry dates. And keep in mind that in January of 2019 you can, of course, create retirement income that will be attributed to the 2019 calendar year.

RESP withdrawals count in the calendar year of settlement. To cover the full year of schooling for 2018/2019 it might be more advantageous to create some RESP income in 2018 and some in 2019. Know your RESP rules as income from government grant portions is treated differently (for tax purposes) compared to your personal RESP contributions. The grant portion is taxable as income in the student’s hands, the contribution amount is not taxable (for once the government realizes that you’ve already paid income taxes on those monies).

I like this brief page from RBC as an RESP primer.

RRSP contributions for calendar year 2018 can be made up to the first 60 day period in 2019. There’s no rush, but you’re already investing on a regular schedule, right?

If you are turning 71 this year your RRSP’s need to be converted to a RRIF or annuity. You have that last chance to make an RRSP contribution before calendar year-end to reduce 2018 taxes. RRIF payments will begin in 2019.

If you are considering a late year investment keep in mind that you will get another $5,500 of Tax Free Savings Account contribution space on January 1, 2019. And of course we do not lose any unused TFSA room, that is carried forward.

You will be granted additional RESP contribution space in January of 2019.

Personal Finance Housekeeping

And James offers a simple and wonderful reminder. This is a good time to do some personal finance housekeeping.

Related: Your year-end financial planning checklist

Do you have beneficiaries set up on all of your registered accounts? Do you need to change any of your beneficiaries?

I’ll add that you might check in on other basic personal finance musts.

Do you have proper insurance? Do you have your will created, or in proper order? Did you make all desired charitable contributions? Do you need a financial plan? Or you on track to reach your personal financial goals. If you don’t have a plan, get one. While we always want to pay attention to fees, you can access a fee-for-service financial planner.

Thanks again to Jason, James and Robb (for allowing me to share these tax planning thoughts with Boomer and Echo readers).

Please leave your comments. If I don’t know the answer, I’ll find someone who does.

Dale is a still-recovering former advertising writer and creative director. He then moved on to become an advisor on lower fee index funds. These days Dale helps Canadians find the many sensible lower fee investment options available by way of his site, cutthecrapinvesting.com

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