Trying to pick investments and manage your portfolio is a daunting task. With so many choices it can be very confusing to the average investor. As a result, many people default to the buy and hold strategy when it comes to managing a portfolio. Why? Because it is easy. Pick an investment and regardless of the ups and downs, hope that over the long term it goes up.
Today, we live in a world where trading is more frequent than ever. I heard that Amazon.com, is held for an average of only seven days; Day traders are more abundant than ever and faster and shorter is the trend.
The downside to trading is it can trigger taxes. Buy and hold happens to be an excellent tax deferral strategy. Don't do anything and you won't pay tax. Sell and buy means you trigger a disposition and therefore an obligation to pay taxes on the profits.
Even the prudent thought of re-balancing a non-RRSP portfolio could trigger tax consequences.
My friend named Joe
Joe is a client. Long before my time in the industry, Joe bought $25,000 of the Templeton Growth Fund. 17 years later, Joe came to see me because his $25,000 had grown to almost $270,000. The good news is that translated to about a 15% compound annual return.
With all the bad press, Joe was beginning to second guess having such a significant investment in one Fund. As Templeton went through a period of underperformance in 1998, Joe came to me looking for advice on whether he should make some significant shifts in his portfolio.
The bad news was that if we were to make some changes and diversify the portfolio into different funds with different management styles and different sectors, there was going to be a significant tax bill. In fact, the estimated tax bill was going to be in excess of $30,000. This was clearly a case of good news he made 15%, bad news-here cometh the taxman.
Mutual fund corporations offer a solution
A few companies have come up with a way around the triggering of tax every time you sell and buy. Companies like C.I., Synergy, AGF, AIM and Clarington (the newest player to enter the corporate arena) have funds that are structured as a corporation instead of a trust.
In a trust arrangement (most mutual funds), all taxable income in the form of interest, dividends and capital gains are passed on to the unit holders. The fund itself does not pay taxes. All tax is flowed through to the investor. For tax purposes, switching from one fund to another is just like selling a piece of property and purchasing another.
Mutual Fund Corporations are unique because they use the corporate structure to avoid the taxman's perception of when a sale or disposition actually occurs. Switching from one “class” (otherwise known as a fund) to another within a corporate structure does not trigger taxes. By setting up an umbrella over the various funds, these structures allow investors to switch from fund to fund without triggering tax until the money is finally withdrawn from underneath the umbrella.
For non-RRSP plans, these funds may be ideal, providing tax deferral on switches and minimizing year-end distributions. Keep in mind that these investments are a deferral strategy and the tax eventually must be paid on the increase in value of the portfolio. The effect of a tax deferral strategy is your money will grow faster because a portion does not get siphoned off to the government every year. In the end you get to control when you want to trigger the gains and pay the tax – something definitely worth controlling!
Throw caution into the wind
While there are many tax benefits to the corporate structure, keep in mind that most of these structures only contain equity investments and in many cases riskier sector type investments. While I'm a strong advocate of tax smart investing, I'm also passionate about understanding risk before investing. Equities have the edge on tax preferred investing but do not lose sight of your risk tolerance and what I call risk budget.
That being said, I think that if you are investing in mutual funds outside of your RRSP, you should take a look at the corporate structure to see if the unique benefits appeal to your situation.