I recently switched my financial accounts from a mutual fund adviser to a discount brokerage and am hoping, over time, to convert most of my mutual funds to exchange-traded fund equivalents. My concerns are related to my non-registered mutual funds, which I have had for quite a while. The funds were set up with regular dividend reinvestment plan distribution. Cashing out those funds will trigger large capital gains. Can I presume that the adjusted cost base stated by my service provider are correct?
Let’s start by defining the terms in your question:
Adjusted cost base. For tax purposes, the difference between the cost of an investment and the proceeds you receive when you sell it is taxed as a capital gain (or loss). Several things can either increase or decrease your ACB, which means you need to keep accurate records to report these gains and losses correctly.
Dividend reinvestment plan. If you hold securities or funds that pay distributions, like interest income or dividends, you may elect to have those distributions automatically reinvested. In a non-registered account, those distributions are taxable in the year you receive them, even if you reinvest them. And for the purpose of calculating your ACB, these are just like a new purchase – they increase your ACB. Note in some cases you may receive “return of capital” distributions, which instead decreases your ACB.
Capital gain or loss: The difference between the proceeds received when you sell an investment and the ACB. If this is a positive number, it will trigger a capital gain. If it’s negative, it triggers a capital loss. When a capital gain is triggered, half of the gain is included as income on your tax return, while the other half is tax-free.
Exchange-traded fund. Like a mutual fund, these are generally baskets of securities containing stocks and bonds. There are some differences between mutual funds and ETFs, but the primary driver of making the switch to ETFs is often lower fees than a comparable mutual fund.
Okay. Now that we understand some financial jargon, let’s dig into your question.
It may seem simple on the surface but calculating the ACB of your investments can be deceptively complex.
A few of the lesser-known factors that affect ACB are: accounting for reinvested distributions, stock splits, return of capital or phantom distributions; calculating ACB across multiple non-registered accounts; verifying the transfer of ACB records when accounts are transferred from one service provider to another; adjusting your ACB for fees and commissions; accounting for foreign currency transactions; errors made by your service provider.
While the details of these factors are beyond the scope of this article, you can probably tell by now that it gets complicated.
Your brokerage or service provider will do their best to calculate the ACB on your positions correctly, but the reality is that you, as the taxpayer, are responsible for keeping accurate records and reporting your capital gains and losses to the Canada Revenue Agency. Providers will usually place a disclaimer on their statements or reports reminding you that the ACB information they provide you should not be used for official tax purposes.
If you work with an accountant, they can help you calculate it. If not, there are some online tools available – but in the end, the onus is still on you to get it right.
You also asked about what approach is best when converting your mutual funds to ETFs. The answer to that will depend on your personal circumstances, but here are some things to consider:
- If the ETFs have lower fees, how much more will you pay by waiting to convert your mutual funds to ETFs? Does this offset some or all of the tax payable on the capital gain? And if not, how long would it take you to recover the capital gains taxes when accounting for the lower fees?
- Are there any deferred sales charges associated with selling your mutual funds? If so, does it make financial sense to wait until these fees are lower, or gone altogether?
- Should you trigger the gains over multiple calendar years to take advantage of lower future tax brackets?
- Is your current portfolio well-diversified and aligned with your risk tolerance, risk capacity and goals? And if not, does the move to your desired ETF portfolio fix this?
- Are you comfortable with the added complexity of doing this transaction over time, or do you prefer the simplicity of doing it all at once?
You told us you don’t have any room in your registered retirement savings plan or tax-free savings plan – great job! – but if you have a spouse or common-law partner, you might consider funding their TFSA. Usually, gifting money to a spouse without setting up a spousal loan would result in any investment income they earn being attributed back to you. But since the income earned in a TFSA is tax-free, you can fund a spouse’s TFSA without triggering these attribution rules.
With any tax decision, consult a professional tax adviser before proceeding.
The good news here is that your investments have grown in value over time. And while we tend to focus on paying the least amount of tax possible, sometimes, ripping off the proverbial Band-Aid and accepting the tax bill is the simplest and most effective answer.
Mark McGrath, CFP, CIM, CLU, is a financial planner and associate portfolio manager with PWL Capital Inc. and a member of the Financial Planners Association of Canada.