When buying mutual funds for a non-registered account, in addition to considering your investment objectives, you may also want to think about the tax consequences. Depending on the type of fund you choose and the type of income generated from the fund, the tax you pay may vary. That's because different types of investments generate different types of income.
Interest
The fixed-income portion of balanced funds, bond funds and money market mutual funds generate interest income. If these funds are held in a non-registered plan, the interest is fully taxable at your marginal tax rate.
As a result, you may want to consider holding interest-generating investments in your RRSP, since the funds can grow tax sheltered, as long as they remain in the RRSP.
Dividends
Income from dividends and capital gains are more tax advantageous to investors. The tax system recognizes that dividends are paid out of income on which the corporation has already paid income tax. To compensate, dividends of Canadian taxable corporations are subject to gross up/dividend tax credit treatment. At the top rate, income earned from dividends is taxed at about two-thirds of your marginal tax rate.
This applies to dividends from Canadian equity mutual funds, as well as from individual stocks of Canadian corporations. Since the tax rate on Canadian dividends is lower than that on interest income, you should consider the after-tax return on the investment to ensure that you are making a fair comparison.
Capital Gains
One-half of your capital gains are taxable at your marginal tax rate. Thus, capital gains are taxed at a lower rate than regular income.
Capital gains can result in two ways:
- When you sell your mutual fund units for more than their original purchase price (for example, if you bought units worth $1,000 and sold them for $1,500, the $500 capital gain you earned would be taxed at one-half of your marginal tax rate).
- When stocks in an equity mutual fund are sold by the investment manager for a gain, you may receive a distribution from the mutual fund as a capital gain. If the capital gains distribution is not actually paid out, you are entitled to add it to your cost base.
Many mutual funds produce capital gains over time, and this is especially true for equity and balanced funds.
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