Dear Expert:
I am looking at mutual funds that invest in dividend-paying common shares, as opposed to those that hold preferred shares, so that I can hope for capital gains along with a decent flow of dividend income. However, I understand I may be subjecting myself to a taxation nightmare, one that is far more complex than if I just bought the dividend-paying stocks directly. With the fund route, I would have to cope with annual capital-gains payouts, annual dividend payouts, plus an ongoing capital gain calculation based on the (hoped-for) increase in the fund units' value. Can you explain to me, in a nutshell, how dividend funds are taxed, and suggest a simple way that I could keep track of my ongoing tax liability? Expert Answer:
Dividend funds are generally mutual funds that invest primarily in equities. These funds attempt to generate both dividends and capital appreciation. At the end of the year, a mutual fund is required to distribute to investors its dividends received as well as any capital gains realized from the sale of equities in the fund. After year-end, each mutual fund will report to its investors the amount of realized capital gains and dividends paid out. They do this by sending out a T3 slip (and a Relevé 16 for Quebec residents) in the case of mutual fund trusts, or a T5 slip (Relevé 3) for mutual fund corporations.
To the extent that unitholders reinvest their distributions of either dividends and/or capital gains, these reinvestments will increase the adjusted cost base (ACB) of their total investment and therefore will reduce (increase) the ultimate capital gain (loss) on the sale of the fund. Most mutual fund companies do a good job at tracking your ACB so that you can easily calculate your gain or loss upon ultimate disposition.
In today's tax environment, capital gains are taxed at 50% of ordinary income, while Canadian dividends are eligible for the dividend tax credit, making dividends also tax-preferred, although not as favourable as capital gains.
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No statement in this article should be construed as a recommendation to buy or sell securities or to provide investment advice or individual financial planning. Morningstar Canada does not provide specific portfolio advice and recommends the use of a qualified financial planner when appropriate.
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