Tax planning in a volatile market

Tax Managed Strategy 16

Stock market volatility may cause investors to worry about their investments, and to make matters worse, the taxable amounts reported at year end may not relate to the value of their portfolio.

Portfolio managers (also called fund managers) who actively trade may trigger gains that are reported as taxable income, and investing just prior to the distribution or allocation date1 may result in the distribution or allocation of income earned prior to the purchase.

There are generally two reasons why you could receive a tax slip even though the value of your investment has dropped.

Income (dividends and interest)

This can be described using a rental property analogy. Receiving taxable income in a down market is like owning an apartment building. The value of the building may be less than when you purchased it, but you’ll still have to include any rent you collect as income. Mutual funds and segregated funds will also report to you any dividends or interest that the fund receives from the investments they hold.

Capital gains

There may be unrealized gains in the fund, or growth in the fund prior to your purchase that hasn’t been taxed yet. This is probably the most difficult to understand — the following three examples may help clarify this concept.

Example #1

If you hold a share directly, you only pay tax when you sell.

This is a line graph showing you buying shares of a security at $100 per share, the shares rise in value and you sell them at $180 per share. In this example, you hold the shares directy and only pay tax upon selling. For illustration purposes only.

A mutual fund or segregated fund is made up of a variety of stocks and securities with many investors. To keep the example simple, let’s assume that the fund only has one stock and you are the only investor.

If you purchase the stock (unit) at a price of $100 and sell it later for $180, you’ll receive a tax slip showing a capital gain of $80. When you sell a stock at a profit, you recognize a capital gain — the difference between your purchase price (cost) and the value you received at the time of sale ($180 – 100). In our example:

  • Gain = proceeds less cost
  • Gain = $180 – 100 = $80

Example #2

You may have a gain even if you don’t sell!

The following line graph shows a different scenario where you have bought a mutual fund instead. In this example, the price of the mutual fund rises over time. There are 3 data points: the fund manager has purchased a stock at $10 a share, you purchased units/shares of the mtuual fund at $100 per unit/share, and the fund manager sells the stock at $180 per share. In this scenario, you may have a gain even when you don't sell.  For illustration purposes only.

The fund is also taxed on its trading activity. So, even though you may have bought into the fund at $100, the fund manager may have purchased this particular stock many years earlier for $10. The $100 you paid represented the value of that stock on that particular day. If the fund manager sells the stock for $180, the fund has realized a gain of $170. By law, this gain must flow through to the investors. If you were the only investor, you’d receive capital gains of $170 even though you’ve only seen an increase in your holdings of $80 since purchase.

It‘s important to keep in mind that not only will you be taxed when you sell your stock (as shown in the previous example), but you’ll also be taxed on gains realized if the fund manager sells the underlying securities. This gain is distributed or allocated to all fundholders at the respective distribution or allocation date.

If the fund manager sells at $180, then the gain is $170. In our example:

  • Gain = proceeds less cost
  • Gain = $180 – 10 = $170

Example #3

You may receive a tax bill even if your investment drops.

The following table continues with the example from Graph #2 above. In this example, the price of the mutual fund rises and declines over time. There are also 3 data points: the fund manager has purchased a stock at $10 a share, you purchased units/shares of the mutual fund at $100 per unit/share, and the fund manager sells the stock at $60 per share. In this example, you may receive a tax bill even if your investment drops in value.  For illustration purposes only.

Let’s take this example one step further. Suppose the fund dropped in value after you bought in. If you recall, your purchase price was $100 and the fund manager’s purchase price was $10. After you buy in, the value drops to $60. If you sold at this time, you’d receive a capital loss of $40 — the difference between your purchase price (cost) and the value you received ($100 – 60).

However, if the fund manager decides to sell at this point the taxable amount reported will be a capital gain of $50 — the difference between their purchase price of $10 and the sale price of $60. In this situation, it’s possible for an investor to receive taxable amounts reported to them even though their investment has dropped in value.

It’s also important to note that an investor never pays tax on more than they actually make in profit. If you pay tax on $50, your cost is increased by that amount and taken into account when you sell the stock yourself. For example, if you sold the stock after receiving the $50 gain, your new cost would be $150. If the stock was still trading at $60 when you sold, you’d now have a capital loss of $90 — the difference between the amount of money you already paid tax on (cost), $150, and the value you received when you sold, $60.

If the fund manager sells at $60, then the gain is $50 even though you’re at a loss if you sold. In our example:

  • Gain = proceeds less cost
  • Gain = $60 – 10 = $50

If you sell (or switch) after receiving the tax slip, your loss will be:

  • Loss = proceeds less cost
  • Loss = $60 – 1502 = –$90

Caution! Late-year investing

Before investing in a fund, consider the impact of distributions or allocations. If there’ll be significant year-end distributions or allocations, consider investing in a dollar-cost averaging or money market fund to avoid the tax impact.

Ideal candidates

Investors who:

  • Are in a loss position but received a taxable amount
  • Are making late year deposits

Take action

If you do have a gain reported, consider one of these strategies:

  • Fund switch to realize capital losses and offset gains.

Switch to another fund to trigger the capital loss and recoup taxes already paid on gains. If the loss is more than the current year’s gain, you can carry back to previous years to offset other gains.

  • Transfer capital losses between spouses.

If you haven’t incurred any capital gains this year or in the previous three years but your spouse (or common-law partner) has, it’s possible to transfer capital losses to your spouse using superficial loss rules. Here’s an example of how this works:

John purchased 100 shares in ABC Co. for $30,000. Later, he sells those shares for $10,000, realizing a loss of $20,000. If Jane, his wife, purchases 100 shares in ABC Co. within 30 days of John selling them, John’s loss is denied under the superficial loss rules and is transferred to Jane (for tax purposes), because she is “affiliated” with John.

Jane then waits a minimum of 31 days and sells those 100 shares for $10,000 incurring a capital loss for tax purposes of $20,000, but no actual monetary loss for her. This allows her to claim John’s $20,000 loss against her taxable capital gains.

See Tax managed strategy #1, Capitalizing on capital losses for more details.

Investment options with Manulife Investment Management

Manulife Investment Management and its subsidiaries provide a range of investments and services, including mutual funds and segregated funds.

Mutual funds can help meet your specific financial needs throughout your life. Whether you’re just starting out, accumulating wealth, or nearing retirement, mutual funds offered by Manulife Investment Management can provide you with solutions to help build a portfolio that meets your needs.

Segregated fund contracts combine the growth potential offered by a broad range of investment funds with the unique wealth protection features of an insurance contract. Through Manulife segregated fund contracts, investors can help minimize their exposure to risk through income, death and maturity guarantees, potential creditor protection features, and estate planning benefits — all from a single product or insurance contract.

1 Distribution date or allocation date can vary by product, i.e., mutual fund corporation, mutual fund trust and segregated fund contract, and by specific fund, i.e., some funds distribute or allocate periodically in addition to year end while for money market and dollar-cost averaging funds, distributions and allocations of fund income are determined on a daily basis. 2 Your original cost of $100 plus the $50 reported to you.

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Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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