Timing your mutual fund trades

Tax impacts a consideration towards year-end

Buying and selling mutual funds must be based on their suitability to an investor’s goals, age, capacity for assuming risk and investment knowledge. Also important is how well they have or are projected to perform. However, there are tax implications to be considered as well, which includes the right time to buy and sell mutual funds, especially at year-end.

Mutual funds, whether organized as a trust or a corporation, take the money raised by selling units or shares in the fund and invest it to earn income. This income may be in the form of interest earned on bonds or similar investments, dividends on equity investments, or capital gains on the sale of investments.

Because the fund itself must pay income taxes on the investment income earned, its managers will typically distribute accumulated earnings to unitholders before the year-end of the fund. Mutual fund trusts must use the calendar year as their fiscal year, so these distributions typically occur late in the year. Some funds, which are designed to provide an income stream, may distribute monthly.

When investing in mutual funds inside an RRSP, RRIF, or TFSA, there are no tax implications. But when these distributions occur in a non-registered account, the liability for the tax on the distributed earnings is passed to the investors who own the units or shares at the time the distribution is made. The Net Asset Value of the fund decreases at the time the distributions are made, so the investor does not gain or lose as a result of the distribution, except when it comes to income tax.

To minimize taxes in non-registered accounts, the best time to buy a mutual fund for most investors is immediately after the distribution, and the best time to sell is immediately before the distribution.

Let’s look at two investors who buy into mutual funds immediately before and after a distribution. For simplicity, assume the funds earn $1,000 during the year and distribute the same amount on December 31. In each case, assume the investor invests $20,000 and sells the investment exactly 51 weeks later.

Example 1. Mary purchases 1,000 units in the fund on December 27, 2019, for $20.00 per unit ($20,000 investment). On December 31 the fund distributes $1,000. This reduces the value of the fund by $1.00 per unit. On her 2019 tax return, Mary will have to report the $1,000 distribution, and her number of units increases to 1,052.63 as the distribution is actually used to purchase more units in the fund. Her investment value remains at $20,000.

Fifty-one weeks later, the Net Asset Value of the units has returned to $20 per unit. Mary sells her 1,052.63 units reaping a capital gain of ($20 x 1,052.63) – ($20,000 + $1,000) = $52.60.

Example 2. Joe purchases 1,052.63 units of the fund at $19 per unit ($20,000 investment) immediately after the distribution. His income tax return is not affected by the investment in 2019.

Fifty-one weeks later, the units are worth $20 per unit, so when he sells his 1,052.63 units, he reports a capital gain of 1,052.63 x $20 – $20,000 = $1,052.60. As a capital gain, his taxable income increases by $526.30.

Summary: Mary reports $1,000 income (could be a mixture of interest, dividends, and capital gains) in 2019 and a capital gain of $52.60 in 2020. Joe only reports a capital gain of $1,052.60 in 2020.

In 2019, Mary has to add between $500 and $1,038 to her taxable income (depending on the mix of income types), and in 2020 she adds $52.60 x 50% = $26.80. In almost every case, she will pay more tax on the income than Joe will on his $526.30 taxable capital gain.

Both investors reap $1,056.30 from their investment, but by purchasing immediately before the distribution, Mary pays more income tax on that income.

In both cases, the investments were sold before the 2020 distribution, so that distribution is not added to either investor’s income for 2020.

Founded by tax expert, award-winning financial educator and best-selling author, Evelyn Jacks in 2003, Knowledge Bureau™ is a widely respected financial education institute and publisher which has welcomed thousands of students from the various financial services to its online and in-class programs. This article originally appeared in the Knowledge Bureau Report. Follow Evelyn Jacks on Twitter @EvelynJacks. Visit her blog at www.evelynjacks.com.

Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.