Watch the mutual funds you buy outside your registered accounts between now and the end of the year. Otherwise, you may find yourself on the hook for taxes if you buy just prior to an end-of-year capital-gains distribution. And the amount you’ll have to pay can, on occasion, be startlingly high.

Most funds, of course, simply reinvest the cash from distributions unless you specify otherwise. But you’re left with the income-tax consequences of that distribution.

Most, or even all, gains realized by your fund so far this year may already be reflected in the net asset value per unit if you buy its units now. But you’ll have to pay taxes on those gains anyway.

The distribution, since it represents cash leaving the fund, reduces the value of the units. But the reinvestment of the distribution gives you more units. So when you ultimately redeem your investment, you’ll have a reduced capital gain to offset the tax you pay this year on someone else’s gain. But in the meantime, you will have, in effect, given the federal and provincial governments an interest-free loan.

If you invested in a mutual fund at the beginning of this year, then you’ll reap the benefits of any capital gains the fund distributes. So at least you’ll be paying tax on profits you made.

Beware investing late in the year

It follows, then, that in general, you should avoid large mutual-fund purchases near the end of the year. Instead, defer large purchases until the beginning of the following year.

Keep in mind, though, that if markets continue to decline in the final months of this year, the buying opportunity provided by lower share prices may well outweigh the potentially negative tax consequences of large year-end purchases.

Remember too, when you sell a fund at a profit, you’ll also have an additional taxable capital gain on gains the fund has made but not yet distributed. Even if you simply switch from one fund to another within the same family of funds, you’ll trigger either a capital gain or a capital loss.

Tax-efficient funds

Some fund companies do, however, offer classes of funds that let you switch between them without realizing a capital gain. Switching occurs on a tax-deferred “rollover” basis with these so-called “corporate class” funds. This means that while you incur no capital gains for tax purposes when you trade between them, you’ll eventually incur a gain when you redeem them.

Since we advise against frequent fund-switching, we’re generally not enthusiastic about these funds, especially since you typically pay higher management expenses with them.

Avoid frequent fund switching

If you switch at the wrong time, you may lose money. If you do so at the right time, you’ll share the profits with the tax-collectors.

Of course, if you shelter your mutual funds in a registered account, you sidestep the tax consequences noted above. There are, however, tax disadvantages to holding mutual funds inside registered accounts.

For one thing, if your fund distributes dividends paid by Canadian companies, the dividend tax credits go to waste. That’s why when you have more than enough money to invest in your RRSP or TFSA, we generally recommend that you arrange your investments in and out of your registered account to achieve the maximum advantage of the dividend tax credit and the lower rate on taxable capital gains.

This means you should start by putting your interest-paying investments in your registered accounts first. That’s because interest income, unlike dividends and capital gains, enjoys no special tax advantage. Interest-paying investments, therefore, work hardest for you when they’re sheltered and their interest can compound tax free.

The TaxLetter, MPL Communications Inc.

133 Richmond St. W. Toronto, On, M5H 3M8, 1-800-804-8846