Today we have another guest post from Ed Rempel. He has graciously taken his time to write an article explaining and giving examples of tax-efficient mutual funds. Could this be a better way of investing with the Smith Manoeuvre?
One of the 3 D’s of tax savings is Defer. Paying tax some time far in the future is much better than paying tax now.
One of the most effective ways of getting huge, compound growth in your portfolio is to pay as little tax as possible along the way. This is why RRSP investments usually grow far faster than non-RRSP investments.
For example, if you invest $100,000 for 30 years at 10% and then pay capital gains tax in 30 years, you will have $1,367,000. If you invest the same but pay tax each year, you will have only $926,000. This is a 48% larger nest egg just for paying the tax at the end instead of some tax each year!
This is why tax efficiency is very important for any investments outside your RRSP, such as the Smith Manoeuvre. Tax efficiency is the percent of your profit you still have after tax. For example, if your fund makes 10% and is 90% tax efficient, then you get a T3 or T5 slip that costs you 1% for the year, leaving you with a net 9% gain for the year.
A bond or GIC will be 50% tax-efficient. The average mutual fund is about 75% tax-efficient, but there are 585 funds that have been 100% tax-efficient for the last 5 years and 72 funds that have been 100% tax-efficient for the last 10 years.
100% tax-efficient mutual funds usually come in 2 flavours – buy-and-hold funds and corporate class funds. In both cases, it is common to NOT pay distributions.
How do they stay tax efficient?
There are 4 main ways they manage to avoid paying any distributions:
1. Buy and hold – Mutual funds pass on taxable income to their investors in the form of a T3 or T5 if they have taxable income within the fund. However, if a fund has a buy-and-hold philosophy and never sells any of its holdings, then there is no taxable income to pass on to the investors.
Most mutual funds have a relatively high turnover rate. They sell 1/3 to ½ of their holdings each year. Therefore, much of their profit must be passed on to their investors each year. However, some funds keep their holdings for many years, so very little tax is ever passed on to the investors.
Warren Buffett is known for buying great companies and holding them forever. Some fund managers follow this philosophy. Since trading more often almost always leads to lower returns, this philosophy usually creates higher returns – plus defers most or all tax.
2. Turnover credit – Mutual funds get a credit for the capital gains of investors that sell the fund. This avoids double tax.
For example, let's say you invest $1 million and are the only investor in a fund. The fund buys one stock that doubles to $2 million. You sell and claim the $1 million gain. The fund gets a credit for the $1 million gain you claim and therefore – the fund pays no tax. If it did, then the same $1 million gain would be taxed twice.
3. MER is tax-deductible – The costs in the MER are tax deductible. The fund nets the taxable part of any taxable capital gains or dividends received against the MER.
For example, if a fund has an MER of 2.5%, then the first 5% in capital gains (50% is taxable) each year is netted against the costs and not taxable.
4. Corporate class – Many fund companies put large groups of funds into one corporation. This has 2 main advantages:
First, losses in one fund can be netted against gains in a different fund. For example, the fund company can net the gain in your resource fund against the loss in someone else’s tech fund, so that you have no tax on the growth of your fund.
Second, a switch from one fund in the corporate class to another is not a taxable event (it is considered a share exchange), so you can move your money around (even to money market) without triggering any tax.
There are quite a few examples of 100% tax-efficient funds. For example, AIC tends to follow Warren Buffett’s buy-and-hold philosophy. Their flagship fund is the AIC advantage fund that was established in 1985 and has never paid a distribution. We have not been using this fund specifically, but it also does not have a large, pent-up gain, since many investors in the fund have sold it at a profit over the years.
Most of the major fund companies have corporate class structures for many of their funds. Two good examples are the C.I. Corporate Class and the Mackenzie Capital Class funds. The C.I. corporate class was set up in 1987 and has only ever paid a distribution once – 1999, when profits were too high in too many funds. They are 94% tax-efficient for the last 15 years. Mackenzie’s capital class was set up in 2000 and has not paid any distributions since inception – so all have been 100% tax-efficient.
If you are investing outside your RRSP, focus on tax-efficiency and you can end up with a 48% higher nest egg.