As year-end approaches, it’s time to start thinking about the tax implications of distributions from your various investments. This year, the tax consequences of bond mutual funds compared with, say, straight-interest GICs have been top-of-mind for many investors. Here’s a quick primer on some of the tax issues involved with bond funds.
In general, interest income from bond mutual funds and Guaranteed Investment Certificates is subject to tax at your top personal marginal tax rate in the year received. For this reason, interest income is regarded as the least efficient form of investment income. However, how and when interest income is taxed depends to a large degree on how the investment is held.
Bond mutual funds generate income in various ways, typically from interest and capital gains. The tax you pay will depend on the type of income the fund generates and distributes to you in the year. In either case, you’ll have to pay tax, regardless of whether or not you reinvest the distributions in more units of the fund. Of course, the question is moot if your investment is held in a registered account like a Registered Retirement Savings Plan (RRSP), a Registered Retirement Income Fund (RRIF), or a registered pension plan. In these cases, tax is deferred until you withdraw funds. In a Tax-Free Savings Account (TFSA), of course, there is no tax payable on income generated by investments within the plan or upon withdrawal.
The same applies to Guaranteed Investment Certificates (GICs), which produce only interest income. GICs can be held in either registered on non-registered accounts. If held in a registered account, tax can be deferred or avoided altogether in the case of a TFSA.
Any mutual fund that holds bonds or similar debt instruments will generate interest income from those bond holdings. These include bond funds, balanced funds, and money market funds. If the fund is held in a non-registered account, any interest income distributed to you from the fund during the year must be reported as income in the year and will be fully taxable to you at your marginal tax rate.
Bond funds will also from time to time generate capital gains from trading bonds in their portfolios. Bonds sold before maturity may result in a capital gain or loss to the fund for tax purposes. In non-registered accounts, those net gains or losses will be reflected in the fund’s distribution to you and must be reported for the year received when you file your tax return. Remember that you may use capital losses to offset capital gains in the current year or in the three years previous years. Losses may also be carried forward indefinitely to be used against future gains.
GICs, of course, are generally not tradeable instruments and therefore do not generate any capital gain or loss.
You must include in income one half of any capital gains distributed from your bond funds held non-registered accounts during the year. That income is then taxable at your marginal tax rate. Because of this 50% capital gains inclusion rule, capital gains are generally regarded as more tax efficient investment income. The same will apply if you sell your bond fund and generate a capital gain on the sale.
When is GIC interest taxable?
GICs generate interest through their full term, but typically they do not pay anything until maturity. However, for tax purposes, interest accrues at the anniversary date of the GIC purchase. For non-registered GIC investments, this interest must be reported in the year it accrues, and the interest will be subject to tax at your marginal rate.
Unlike GICs, which are fairly straightforward from a tax perspective, the tax consequences of bond funds in registered and non-registered accounts can get complicated, especially if you also buy and sell units of the fund or funds in the year, affecting your adjusted cost base (ACB). In this case, it may be prudent to consult a professional financial advisor to help you stay onside with the Canada Revenue Agency.
Courtesy Fundata Canada Inc.© 2016. Robyn Thompson, CFP, CIM, FCSI, is president of Castlemark Wealth Management. This article is not intended as personalized advice. Securities mentioned are not guaranteed and carry risk of loss. No promise of performance is made or implied.