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Mailbag: Dealing with a ‘crazy’ portfolio, buying mutual funds and more

It's been a while since I looked into my questions file, so let's do that now. Here are some of the issues that have been concerning readers.

Dealing with a "crazy" portfolio

Q – I have been asked to take over managing my aging father-in-law's investments. He is 88 and obviously near the end. Part of the equation is preservation, ensuring the funds are there for him, and the secondary consideration is growth for the future inheritors.

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Reviewing the portfolio, I find it is extremely risky: gas, oil, and mining stocks exclusively. I am thinking dividend income is the way to go. His risk tolerance as per the planner's paperwork is 65-per-cent growth. I believe it was filled out over 10 years ago. My question is how do I transition from this seemingly crazy portfolio and secondly start the process of finding a good financial planner? - John R.

A - I agree the portfolio should be concentrated in less risky securities – a mix of low-risk dividend stocks, preferred shares, and perhaps a laddered GIC. The fact the advisor did not undertake this transition years ago and continued to administer a risky portfolio for an aging person suggests he wasn't paying attention.

Ask to speak to his manager and explain your concerns. Tell them what you want to achieve and ask how they will go about it. Keep in mind that he may have some capital gains from his stocks so selling them could trigger tax liabilities. If so, plan accordingly. See how the manager responds. If you don't get the results you want, take the business elsewhere. – G.P.

Why buy mutual funds?

Q – Why would anyone buy a mutual fund? Do the math - 3-per-cent inflation plus 2.5-per-cent management fee plus 1.5-per-cent maintenance = 7 per cent. So for me to "get ahead" I have to buy a fund that exceeds 7 per cent a year. Of the thousands of funds out there just how many exceed 7 per cent? It would seem that only someone stupid would buy a mutual fund. Or, is there some thing I am missing? Thank you. – Neil

A - What you are missing is some accurate math. For starters, inflation is not running at 3 per cent or anything near that. The October annualized inflation rate reported by Statistics Canada was 1.4 per cent. Second, you have added a management fee of 2.5 per cent to a "maintenance fee" of 1.5 per cent, for a total of 4 per cent. There is no such thing as a "maintenance fee" as such. You need to look at the fund's management expense ratio (MER) for the total percentage of all fees and taxes. For an equity fund, that is usually in the 2-per-cent-3-per-cent range, although there are some that are cheaper. A fixed income fund will typically have an MER of 1 per cent-2 per cent.

Let's assume an equity fund with an MER of 2.5 per cent Add inflation and you need an annual return of 3.9 per cent to break even by your standards. How many Canadian equity mutual funds achieve that? I did a Globefund search for five-year returns that resulted in 627 hits. These aren't all individual funds – many are different series of the same fund. But it gives you an idea that a lot of mutual funds meet your criteria.

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But here's another point to consider. Fund returns are calculated after all fees and expenses have been deducted. So really you only have to beat the inflation rate to come out ahead. – G.P.

Return of capital

Q - I am having trouble understanding the long-term effect of return of capital in mutual funds and trusts. I have been told I should use this mechanism to defer tax but I am not sure it is a good idea. I would be interested in your comments on return of capital. It just doesn't seem like I am actually making money with them. – Dave S.

A – Return of capital doesn't necessarily mean you are just getting your money back. For tax purposes, return of capital can be generated by previous business losses, depreciation, and other accounting items. If part of a distribution from a mutual fund or REIT is classified as return of capital, you are not subject to any tax in the year it is received. The tax is deferred to the year in which you sell the security. Putting off tax for as long as possible is almost always beneficial.

Any return of capital payments are subtracted from your costs, to produce what is known as an adjusted cost base. For example, suppose you pay $10 for a mutual fund unit. The next year you received distributions that include a 50-cent return of capital. Your adjusted cost base is now $9.50 ($10 - $0.50 = $9.50). If you were then to sell the security for $11, your taxable capital gain would be $1.50 per unit ($11 - $9.50 = $1.50).

You benefit in two ways from this. First, you defer any tax until you sell. Second, when you do sell you are taxed at the capital gains rate on the return of capital distributions, which is normally advantageous. – G.P.

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U.S. stocks and TFSAs

Q - Is it safe to hold U.S. stocks in a TFSA? Will capital gains be subject to U.S. withholding tax? I understand that registered accounts are non-taxable for capital gains on U.S. assets. – Dale W.

A – There seems to be a lot of confusion about U.S. stocks in a TFSA so let me try to clear this up. Only U.S. dividends are subject to withholding tax in these accounts. Capital gains are treated the same way as gains on Canadian stocks – they are tax-free.

U.S. dividends received in an RRSP or RRIF are not subject to withholding tax because those plans are designated as retirement accounts under the Canada-U.S. Tax Treaty. – G.P.

RRIF conversion

Q - If I generate $2,000 in a partial conversion RRIF (I'm 66) will I receive that $2,000 in dividends tax-free? – Beth M.

A – All money withdrawn from a RRIF or RRSP is normally considered to be regular income and taxed at your marginal rate. However, for anyone 65 or older, the first $2,000 of RRIF income is eligible for the pension tax credit. The credit is 15 per cent of the allowable amount, or $300. The net result is that if you are in the lowest tax bracket that first $2,000 is tax-free. If you are in a higher bracket, you receive a reduced rate. – G.P.

I'd be happy to consider all personal finance and investing questions, although I cannot guarantee a personal answer. Send them to me at gpape@rogers.com and write Globe Question on the subject line. I'll answer the most interesting ones in future columns.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.

Follow Gordon Pape on Twitter at twitter.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

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