Discover the advantages of segregated funds

Investment insight

While the taxation of non-registered segregated fund contracts is similar to the taxation of non-registered investments in mutual fund trusts,¹ there are some differences that are advantageous to investors. Segregated fund contracts also provide estate and creditor protection benefits that aren’t available to mutual fund trusts.

Taxation similarities

Flow-through of income and capital gains

Both mutual fund trusts and segregated funds may earn taxable income (i.e., interest, foreign income, and Canadian dividends). In addition, each may realize capital gains at the fund level. Both will flow-through all taxable income and realized capital gains to investors. This avoids having income taxed inside the fund at the top marginal rate.

In addition, both act as a conduit—income and capital gains retain their characteristics as they flow through to investors and appear on the T3 (RL-16 in Quebec), and these amounts are taxed the same as if the investor earned them directly. Interest and foreign income are fully taxable, Canadian dividends are grossed-up and receive their dividend tax credits, and only half of a realized capital gain is taxable.

Systematic withdrawal plans

When a mutual fund trust or segregated fund contract owner wants a consistent income stream from their portfolio, they can set up a systematic withdrawal plan (SWP). A SWP is a fixed-dollar withdrawal that occurs on a regular basis (e.g., monthly). The tax treatment of a SWP is similar for mutual fund trusts and segregated funds. That is, at the time of each withdrawal, there’s a sale of units2 to fund the withdrawal. This sale will trigger a capital gain or loss. As a result, receiving an income stream in this manner is very tax efficient.

Mutual fund distributions vs segregated fund allocations

While the flow-through and tax treatment of income and capital gains are identical for mutual fund trusts and segregated funds, the mechanics for getting there are different. Mutual fund trusts will distribute the amounts to investors and the unit value decreases by the amount of the distribution per unit. Investors can receive these payments in cash or have them automatically reinvested back into the fund. The latter requires purchasing new units of the fund.

Segregated funds allocate the amounts to investors. Since no amounts are actually paid, unit values don’t change and no additional units are purchased. If an investor wants the cash value of their allocations, they can redeem the appropriate amount of units after the allocation. To see the differences between distributions and allocations, consider the following example:

This table shows the similarities and differences between mutual fund distributions and segregated fund allocations. In each case, $100 of income accrues. Whether it’s paid as a distribution or allocated, the $100 is still taxable and increases the investor’s adjusted cost base.

In this example, at year end, the investor has the same total adjusted cost base (ACB) as their original purchase, but the market value in both the mutual fund trust and segregated fund has increased by $100 of accumulated income. After the mutual fund trust distributes $100 ($1/unit), the unit value drops to $10. The cash is used to immediately purchase an additional 10 units. The result is the investor has the same market value as year end, but the ACB is now $1,100 and the investor has an additional 10 units. Since the segregated fund allocation isn’t paid in cash, the unit and market values at year end and after the allocation remain the same. Like the mutual fund, the ACB after allocation increases to $1,100, but the number of units held remains at 100. In both cases the $100 of income is reported to the investor on a T3 and they receive the same tax treatment.

Taxation differences

Flow-through of capital losses

A mutual fund can’t flow-through capital losses to unitholders. Rather, losses are subtracted from the capital gains within the fund and only the net capital gains will be distributed to an investor and shown on a T3. In a year where losses are greater than gains, the excess losses can’t be distributed and are carried forward to offset gains in a future year.

Segregated funds can flow-through and allocate capital losses to investors. For example, in a year where there are both capital gains and losses to report, investors will have an amount reported in box 21—capital gains on their T3 (Box A on RL-16 in Quebec)—and an amount in box 37—insurance segregated fund net capital losses on their T3 (Box A on RL-16 in Quebec).3

Advantage for a segregated fund investor

Capital losses not used in the current year can be carried back three years or carried forward to future years. Since mutual fund trusts can’t distribute capital losses, they can only be used to offset realized capital gains in the fund itself. Segregated funds can allocate both capital gains and losses to the investor. So, it’s the investor, not the fund, that can claim any excess capital losses.

All taxable events reported

With a mutual fund, only the distributions relating to fund activity are reflected on an investor’s T3. If investors redeem any of their units, they must calculate the gains and losses themselves and report these on their tax returns. These redemptions are reported to investors on form T5008 (RL-18 in Quebec). Investors are also responsible for tracking their own adjusted cost base, which is needed to calculate their capital gains or losses related to their mutual fund trust.

Advantage for a segregated fund investor

Since the insurer tracks the cost base for each investor, all taxable events are reflected on a T3 (RL-16 in Quebec). There’s no additional accounting required by an investor. This simplifies the tax reporting for the investor relative to holding a mutual fund trust.

Estate benefits

Segregated fund contracts are insurance (annuity) contracts and, as such, a beneficiary can be named to receive any proceeds on the death of the life insured (annuitant). This means the proceeds are paid directly to the beneficiary and don’t flow through the estate, and therefore, will avoid legal, estate administration, probate,4 and other fees associated with the settling of an estate.

To get the same benefit of bypassing the estate, mutual funds are often held in joint ownership,5 particularly with spouses, even though the assets may belong to only one of the owners. When one owner dies, the assets automatically become the property of the other owner. However, be careful with joint ownership, particularly in situations where the joint owner isn’t a spouse or common-law partner as there are many potential drawbacks and risks with joint ownership, such as income attribution, exposing assets to family law claims, and some loss of control for the original owner as oftentimes the signature of both owners is required for many transactions. See our “Joint tenants with right of survivorship—an appropriate strategy?” article for more information.

Under Manulife segregated fund contracts, any revocable beneficiary can be named without affecting the ability of the owner to manage the account. The beneficiary can also be changed at any time without the beneficiary’s consent. Joint ownership of a mutual fund can’t be changed unless both owners agree.

Advantage for a segregated fund investor

The ability to name a beneficiary on a segregated fund contract can provide a cost-effective way to transfer wealth, especially on non-registered accounts where this option may not otherwise be available. This not only avoids the costs associated with settling an estate, but the transfer can happen quicker than if the assets flowed through the estate.

Creditor protection

Creditor protection may also be available if the named beneficiary is a member of the family class or an irrevocable beneficiary. In provinces other than Quebec, a family class beneficiary would be any of the spouse,6 child, grandchild, or parent of the annuitant. In Quebec, a family class beneficiary would be any of the following: married or civil union spouse, or descendants or ascendants of the policyholder.

Advantage for a segregated fund investor

Creditor protection on non-registered investments is only available through an insurance company product, like a segregated fund contract with the same requirement as described earlier (i.e., that the appropriate beneficiary designation is made). In addition, the investments can’t be deposited into an insurance investment merely to avoid existing creditors. Creditor protection can be particularly attractive to business owners, officers, and directors of a corporation looking to protect personal assets from creditor claims related to their business.

To discuss these advantages in detail and learn more about segregated fund contracts, contact your advisor.

This article excludes mutual fund corporations even though many of the aspects discussed would also apply. While exchange-traded funds (ETFs) are generally structured as mutual fund trusts, for simplicity we focus on comparing segregated fund contracts with traditional mutual fund trusts only. For a comparison of the taxation of all of these products, see “Comparing the taxation of mutual funds, exchange-traded funds, and segregated fund contracts.” 2 Technically, an investor owns a segregated fund contract but not actual “units” of a segregated fund. However, their contract value is measured by notional units based on the assets held in the segregated fund. For this article notional units will simply be referred to as units. 3 Box A on the RL-16 provides a net capital gain or net capital loss for segregated fund contracts. If there are no brackets, the amount is a net capital gain. Where the reported amount is in brackets it’s a net capital loss. The amount in Box A can’t be negative for mutual fund trusts and will either be positive or zero. 4 The probate process and fees don’t apply in Quebec. There’s a verification process for non-notarial wills but not for notarial wills. 5 Joint ownership with right of survivorship doesn’t apply in Quebec. 6 For creditor protection, the definition of spouse may include a common-law spouse, depending on provincial legislation.

Any amount that is allocated to a segregated fund is invested at the risk of the contract holder and may increase or decrease in value.

This communication is published by Manulife Investment Management.  Any commentaries and information contained in this communication are provided as a general source of information only and should not be considered personal investment, tax, accounting or legal advice and should not be relied upon in that regard. Professional advisors should be consulted prior to acting based on the information contained in this communication to ensure that any action taken with respect to this information is appropriate to their specific situation. Facts and data provided by Manulife Investment Management and other sources are believed to be reliable as at the date of publication.

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MK1836E 02/23

Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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