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.
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.
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|
Typical income received by various mutual fund types
|Interest||Canadian dividends||Capital gains||Foreign nonbusiness income||ROC|
|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.
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.
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.
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 circumstances 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.
For more information about the taxation of investments, please speak with your advisor or a qualified tax specialist.