I recall hearing that one shouldn't purchase mutual funds in December. Why is that?
Not just mutual funds. Exchange-traded funds, too. The reason has to do with the taxable year-end capital gains distributions that many mutual funds and ETFs make.
Let's look at a simple example. Say in early December you buy one unit of a fund with a net asset value (NAV) – or price – of $20. We'll further assume that during the year the manager sold a bunch of stocks that had appreciated in value and ditched a few dogs, and that the fund is sitting on a net capital gain – capital gains minus capital losses – of $5 a unit.
When that $5 is distributed at the end of the year, the NAV of the fund will drop to $15 a unit. No biggie, right? You still have $20 – one unit worth $15 and a $5 distribution.
Not so fast. If you hold the unit in a non-registered account, half of that $5 capital-gains distribution will be included in your income and taxed. Assuming a marginal tax rate of 40 per cent, you'll have to pay $1 to the Canada Revenue Agency.
So, all else being equal, you'll only have $19 in value to show for your initial $20 investment – all because you bought your unit right before the taxable capital gains distribution. Had you bought the units earlier in the year, you would at least have benefited from the capital gains that were accruing inside the fund.
In real life, the process is slightly more complicated. Year-end capital gains distributions are typically not paid in cash but are instead reinvested back into the fund. But the net effect on your wealth is the same, because reinvested distributions are still taxable.
With taxable accounts, "it's generally a good idea to avoid late-year purchases of equity funds or other funds that have had a very strong run," says Dan Hallett, vice-president with HighView Financial Group.
There are a few ways to avoid the year-end tax hit. One is to postpone mutual fund and ETF purchases until January. Alternatively, if you are determined to buy in December, you could purchase your funds inside a registered retirement savings plan or tax-free savings account to avoid taxes altogether.
The tax hit doesn't affect all funds equally, Mr. Hallett says. "Investors in truly passive index funds usually don't have to worry about year-end purchases since capital gains distributions aren't paid every year, and when they are the amounts are small," he says.
On the other hand, actively managed funds or those that use a mechanical strategy to buy and sell stocks may be more likely to generate capital gains.
Want to know if a fund is preparing to make a year-end distribution? Mutual-fund companies provide estimates of these distributions in advance, "but they don't publicize them the way they used to," Mr. Hallett says. If you can't find the information on the fund company's website, call your adviser (if you have one) or contact the fund company directly, he says.
In the case of an ETF, companies typically publish comprehensive capital-gains estimates in November for all of their funds. For example, BlackRock Canada, which manages iShares ETFs, posted a Nov. 23 press release on its website (blackrock.com/ca) under "tools and resources," "resource library" and "press releases."
Based on the estimates, several iShares funds – particularly those that invest in the U.S. market and have gains from currency hedging – are expecting sizable capital-gains distributions.
The iShares U.S. Fundamental Index ETF (CLU), for instance, is expected to have a reinvested distribution equivalent to about 9.3 per cent of the fund's NAV (as of Nov. 15). The ETF "experienced capital gains in 2017 as a result of the appreciation of securities held in its portfolio, which were sold in connection with portfolio rebalancing," BlackRock says. The fund also realized capital gains related to hedging of its exposure to the U.S. dollar.
Final reinvested distribution amounts for iShares funds will be announced "on or about" Dec. 20, BlackRock says. The record date for the 2017 annual distributions is Dec. 29, 2017 (payable on Jan. 4, 2018) meaning investors who purchase iShares units on or after Dec. 28 will not receive the distributions – and won't be stuck with paying the tax.
Several Bank of Montreal ETFs that invest in the U.S. market are also expecting year-end reinvested distributions. The BMO S&P 500 Hedged to CAD Index ETF (ZUE), for instance, expects a reinvested distribution of about 6.3 per cent of the ETF's current NAV. The record date for BMO's year-end distributions is Dec. 28 – one day earlier than iShares – which means investors who purchase on or after Dec. 27 won't receive them.
Not all U.S.-focused ETFs are affected. The plain-vanilla BMO S&P 500 Index ETF (ZSP) and its U.S. dollar version (ZSP.U) – neither of which use currency hedging – are not expecting any reinvested distributions. Similarly, most ETFs that invest in the Canadian market are expecting small year-end distributions, or none at all. For a full list of estimates, see BMO's news release at http://bit.ly/2i5fQJj.
Year-end capital gains distributions can cause unexpected tax grief, but if you choose your funds carefully and time your purchases properly, you can minimize or eliminate any nasty surprises.