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Distributing income earned by mutual fund holdings benefits unitholders by minimizing overall taxes paid by the fund. Since mutual fund trusts are taxed at a rate equivalent to the highest personal tax rate, any income retained by a mutual fund is typically subject to more tax than if it were taxed in the hands of individual investors.
Distributing income to unitholders, most of whom are taxed at a lower marginal tax rate than the mutual fund, generally results in a lower amount of total taxes paid. By reducing tax paid by the fund, more income can be distributed to investors, which improves the return on their investment.
Mutual fund corporations, however, only provide a limited flow-through, in that only Canadian dividends and capital gains can be passed on directly to investors. Interest and foreign income earned inside a mutual fund corporation are taxable first inside the corporate structure.
Foreign non-business income Foreign non-business income may be earned by mutual funds that invest in foreign securities. While you must report 100% of income earned from foreign sources on your tax return, you may be able to claim a foreign tax credit for income taxes already paid to foreign jurisdictions. If applicable, both of these amounts will be shown on your year-end tax slips.
A cash payment
A reinvestment in more units at the prevailing unit price
Regardless of which option you choose, you are generally required to include distributions as part of your taxable income for the year in which you receive them if held outside of a registered plan such as a RRSP or a TFSA. The exception is return of capital (ROC) distributions.
Distributions from your investments can be paid monthly, quarterly or on annual basis. Usually in February each year you will receive all of the information you need from the fund company to accurately report the income distributed to you for tax purposes.
- The T3 tax slip (Relevé 16 in Quebec) shows the interest, dividends, capital gains, ROC and foreign income you received during the year, as well as any foreign income taxes paid. Income that benefits from favourable tax treatment, such as dividends eligible for the enhanced dividend tax credit, is also clearly identified.
- The T5 tax slip (Relevé 3 in Quebec), or Statement of Investment Income, is issued to investors who own mutual funds in a corporate structure.
Typical income received by various mutual fund types
| Interest | Canadian dividends | Capital gains | Foreign nonbusiness income | ROC | |
|---|---|---|---|---|---|
| Fixed income | |||||
| Canadian equities | |||||
| U.S. equities | |||||
| International equities | |||||
| Emerging markets equities | |||||
| Balanced Funds/Funds of Funds | |||||
| T5 Series/ RBC Managed Payout Solutions |
The above chart is based off historical investment characteristics and does not guarantee each type of distribution with certainty.
Please note that a fund may distribute income even in years when the fund drops in value. This is similar to how a stock or bond will typically still pay dividends or interest even when markets cause the prices of those securities to decline in any given year.
What are the different types of distributions?
Here are descriptions of the different types of distributions you may receive from a mutual fund and how they are taxed.
| Type of distribution | Description | Tax Treatment |
|---|---|---|
| Interest | Earned on investments such as treasury bills, GICs and bonds | Fully taxable at the same marginal tax rate as ordinary income |
| Canadian dividends | Occurs when funds invest in shares of Canadian public corporations that pay dividends | Preferential tax treatment for individuals through dividend tax credits as either eligible or non-eligible dividends |
| Capital gains | Realized when an investment within the fund is sold for more than the ACB | Preferential tax treatment as only 50% of a capital gain is taxable |
| Foreign non-business income | Earned when the fund receives dividends, interest or other types of distributions from non-Canadian investments | Fully taxable at the same marginal tax rate as ordinary income |
| Return of capital (ROC) | ROC is used to describe distributions in excess of a fund’s earnings (income, dividends and capital gains). For tax purposes, ROC represents a return of an investor’s own invested capital | Not taxable in the year received, but reduces the ACB of the fund, which generally results in a larger capital gain (or smaller capital loss) when the investment is sold |
Interest income is earned on securities, such as treasury bills and bonds, and is not eligible for any special tax treatment. It is taxed at the same rate as ordinary income. Interest distributions are reported as “Other Income” on the T3 tax slip.
Dividend income may be earned when a fund invests in shares of public companies that pay dividends. Individuals who receive eligible dividends from Canadian companies can claim a federal tax credit (a provincial dividend tax credit may also apply) to reflect the fact that the company paying the dividend has already paid Canadian tax on its profits. Because of their favourable tax treatment, dividend-paying stocks are popular with investors seeking to maximize after-tax cash flow from their investments.
Over the course of the year, an equity fund will buy and sell various securities within the portfolio. If this trading activity generates more realized gains than losses, the fund will distribute capital gains to investors at the end of the year. Because only 50% of a capital gain is subject to tax, these distributions are considered to be very tax efficient.
| Here's an example: | ||
|---|---|---|
| Market value at time of sale | a | $1,500 |
| Original cost of investment | b | $1,000 |
| Capital gain on sale of investment (a − b) | c | $500 |
| Capital gains inclusion rate for tax reporting (50% of c) | d | $250 |
| Federal tax payable (d x 26%) | e | $65 |
| Federal tax rate on capital gain (e ÷ c) | f | 13% |
The example assumes that an investor has a marginal tax rate of 26%. Note that provincial taxes would also apply and tax rates vary according to province.
Taxes and investing in mutual funds
This PDF guide provides general tax information related to the purchase and sale of mutual fund investments in a nonregistered account, with a specific focus on how mutual fund distributions are taxed.
Download the guide
ROC represents a return to the investor of a portion of their own invested capital. ROC often occurs when a fund’s objective is to pay a fixed monthly distribution to unitholders.
Since ROC represents a return to the investor of a portion of their own invested capital, payments received are not immediately taxed as income. However, ROC distributions reduce the ACB and impact the capital gains tax an investor is required to pay when they eventually sell their investment. At that future date, the deferred taxes will cause the capital gain to be larger (or the capital loss to be smaller).
It's not what you earn - it's what you keep: An example of the impact of taxes on your investment income
Net after-tax cash flow on $1000 of investment income
For the purposes of this example, a marginal tax rate of 26% is used. Please note that rates are unique to the tax circ*mstances of each individual and are provided herein for illustrative purposes only. In addition to the federal taxes noted in the example, provincial taxes are required to be paid. The amount of provincial taxes will vary according to province (provincial dividend tax credits also apply). When combined, the total of the federal and provincial taxes equals the taxes owing on taxable Canadian dividends.
* Represents eligible Canadian dividends with a federal tax credit of 15.02%.
† ROC distributions are not taxable in the year they are received, but do lower your ACB, which could lead to a higher capital gain or a smaller capital loss when the investment is eventually sold.
Note: All figures are rounded to the nearest whole number. Tax rates are subject to change.
Additional resources
Disclosure
Last reviewed: January 1, 2023Please consult your advisor and read the prospectus or Fund Facts document before investing. There may be commissions, trailing commissions, management fees and expenses associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. RBC Funds, BlueBay Funds and PH&N Funds are offered by RBC Global Asset Management Inc. and distributed through authorized dealers. The strategies and advice in this document are provided for the general guidance and benefit of our unitholders based on information that we believe to be accurate, but we cannot guarantee its accuracy or completeness. Readers should consult their own professional legal, financial and tax advisors when planning to implement a strategy. This will ensure that their own circ*mstances have been considered properly and that action is taken on the basis of the latest available information. Interest rates, market conditions, special offers, tax rulings and other factors are subject to rapid change. This document is not to be construed as an offer to sell or a solicitation of an offer to buy any securities.
As a financial expert with a deep understanding of investment vehicles, I want to delve into the comprehensive information provided in the article, covering various concepts related to mutual funds, ETFs (Exchange-Traded Funds), and alternative investments, particularly focusing on RBC (Royal Bank of Canada) offerings.
Let's begin with mutual funds. The article emphasizes the tax implications of distributing income earned by mutual fund holdings. One notable point is that mutual fund trusts are taxed at the highest personal tax rate, making it advantageous to distribute income to unitholders who are often taxed at a lower marginal tax rate. This strategy minimizes overall taxes paid by the fund, enhancing returns for investors.
The distinction between mutual fund trusts and mutual fund corporations is crucial. While trusts can pass on Canadian dividends and capital gains directly to investors, interest and foreign income earned within a mutual fund corporation are initially taxable within the corporate structure.
Moving on to types of investments, the article provides a breakdown of income received by various mutual fund types, including Canadian equities, U.S. equities, international equities, and emerging markets equities. The distinction between the T3 tax slip (Relevé 16 in Quebec) and T5 tax slip (Relevé 3 in Quebec) for reporting different types of income is also highlighted.
The article elaborates on the types of distributions from mutual funds and their tax treatments. These include interest, Canadian dividends, capital gains, foreign non-business income, and return of capital (ROC). Understanding the tax implications of each distribution type is crucial for investors.
Additionally, the article provides an illustrative example of the tax treatment of capital gains, emphasizing the importance of considering both federal and provincial taxes. It further introduces the concept of ROC, emphasizing its impact on the adjusted cost base (ACB) and eventual capital gains tax when the investment is sold.
Transitioning to ETFs, the article introduces RBC iShares ETFs and explores different ETF investment strategies. ETFs offer a unique structure, combining features of mutual funds and stocks, providing investors with diversification and liquidity.
Lastly, the article touches on alternative investments, emphasizing the need for diversification beyond traditional asset classes. RBC's alternative investments aim to provide investors with unique opportunities outside of traditional stocks and bonds.
In summary, this comprehensive article covers the tax implications of mutual fund distributions, types of investments within mutual funds, details about ETFs, and the importance of alternative investments in building a diversified portfolio. It serves as a valuable resource for investors seeking a deeper understanding of these financial concepts.
