Understanding distributions: Issues and strategies for the tax-smart investor

Chances are that if you hold certain mutual funds as part of your taxable investment portfolio, in March of every year you will receive a T3 slip in the mail related to your funds.

What does this slip mean? It means that the mutual fund you’ve invested in has distributed a portion of the income and capital gains earned within the fund to you, the unitholder.

This brief introduces you to mutual fund distributions, what they are, and why they should be disliked by the tax-smart investor who is focused on minimizing their tax bill.

A mutual fund trust is a separate entity under the Income Tax Act of Canada and is taxed on all income, dividends and capital gains earned in the trust that is not distributed out to investors (unitholders).

Since mutual fund trusts are taxed at the highest marginal rate on all forms of income earned, fund companies typically avoid paying this high rate of tax inside the trust by “flowing out” or “distributing” to investors the income and capital gains earned within the fund on all investments since the last distribution date. This is generally wise because investors themselves can then pay tax on the distributions, hopefully at a lower rate of tax.

When a mutual fund trust distributes income and capital gains, the type of income or capital gains retains its character in the hands of the investor, whether it is dividends, capital gains, or interest.

That means you, as an investor, pay tax on these distributions at your marginal tax rate according to the type of income or capital gains received.