Tax Efficient Mutual Funds Canada

Sometimes, when people hear about earnings, finance, savings, and investments, they get nervous because of one thing — Taxes! They can be that scary, probably because they’re unavoidable and hard to calculate. A study showed the average Canadian family pays over 40 percent of their income on taxes. Don’t want to be a part of this statistic? We don’t blame you. So, is it possible to get tax efficient mutual funds in Canada? Of course, it is. If you want to invest in mutual funds, but the fear of taxes is holding you back, this article is for you. Below, we’ll look at various tax efficient mutual funds in Canada and how you can add them to your portfolio today.

Tax Efficient Mutual Funds Canada

Why Does Tax Efficiency Matter With Mutual Funds? 

Tax efficiency is not just important for mutual funds. It cuts across every form of income and savings plan. Imagine you calculate your gross income and arrive at a huge amount, only to deduct taxes and arrive at little. If you don’t consider the after tax numbers, you may make bad financial decisions because you’re cutting out an important, unavoidable expense.

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Now, apply the same logic to your mutual funds. After spending some money on management fees and investing in mutual funds, you’d also have to pay taxes on your investment earnings. Mutual funds earn money through two strategies. The first is through investment income, such as dividends or interest. You also earn income if an investment within the mutual fund is sold for a profit. However, the investment might be sold at a loss too. Either way, gains and losses on sold investments are subject to capital gains tax. You may be thinking you’re making a profit, but don’t spend it all right away because you have a tax bill to think about!

Naturally, we all want to maximize our profits and minimize our tax burdens. This is the ultimate goal of investors, sometimes referred to as tax efficient investing. For this reason, tax efficiency is important for all kinds of investments, particularly mutual funds.

Related Reading: Maintaining Tax Efficiency at Every Age

How Do I Invest in Mutual Funds to Avoid Tax?

You can manage your mutual funds in such a way to reduce some tax burdens. You may have to change some of your investing habits, but it’ll pay off in the long run. Below are five ways to do that:

1. Hold those investments a little longer

You may be trying to sell your investments fast to make a quick buck in the form of capital gains. However, it’s best you consider a longer period of investment where you won’t sell until much later. Remember your capital gains are taxable. Deciding not to sell your investments yet makes you amass more gains, which translates to fewer taxes in the long run.

2. Net zero gains

Under Canadian tax law, capital losses can only be applied against capital gains. If you have a large capital gain, consider selling an investment before the end of the year with a loss to offset the gain and vice versa. This process is called tax loss harvesting and is an excellent strategy for maintaining tax efficient mutual funds in Canada.

3. Watch out for taxes on dividends

Unfortunately, there isn’t a way to offset the tax on dividends the same way you can with capital gains and losses. For this reason, be mindful of your dividend payouts and what your combined tax rate will be on it. Dividends are a great way to form a passive income stream, but remember the tax!

4. Use a retirement account for your mutual funds

You can explore retirement accounts like the RRSP (Registered Retirement Savings Plan). That is, if you want tax efficient mutual funds in Canada. Such retirement accounts aren’t usually taxable until you withdraw from the account. This means you won’t have to pay tax on capital gains or investment income until much later.

Related Reading: Tax Efficient Retirement Withdrawal Strategies in Canada

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Which Mutual Funds Are Tax Efficient in Canada?

As eluded to above, the most tax efficient mutual funds in Canada are those that have low or no dividends. While a steady stream of dividends is ideal as an income stream, it is not tax efficient. If your goal is to establish a steady source of passive income, then tax efficient mutual funds might not be the way to go. But if you want to avoid tax as much as possible, check out the list below.

Remember, it is also necessary that you hold onto your tax efficient mutual fund investments for as long as possible to avoid capital gains tax. Anytime you sell an investment, this tax is triggered, so don’t sell!

Fund NameMERNAVDividend Yield
Mid-Cap Growth Equity Fund0.80%$32.610%
Scotia Low Carbon Global Balanced Fund1.99%$9.870%
Health Sciences Opportunities Fund0.85%$71.060.55%
RBC Canadian T-Bill Fund0.21%$100%
Large Cap Focus Value Fund0.54%$17.770.57%
All amounts accurate as of May 2023.

What Is The Most Tax Efficient Fund?

As mentioned, the most tax efficient funds are those with low to no dividends. From the list above, the most efficient are the Mid-Cap Growth Equity Fund, Scotia Low Carbon Global Balanced Fund, and RBC Canadian T-Bill Fund.

Are ETFs More Tax-Efficient Than Mutual Funds in Canada?

ETFs, short for Exchange Traded Funds, are very similar to mutual funds. However, the main difference is how you buy into them. Mutual funds involve pooling money with other investors with the objective to purchase assets. This means the investor can choose how much they want to put into the fund, may it be $1 or $100,000. But with an ETF, the investor pays market price for a unit of the fund. They cannot choose how much to put in, the amount is determined by the free market.

ETFs and mutual funds are not more or less tax efficient as a whole. It all boils down to the features of the specific investments. If an ETF or mutual fund has a low or no dividend, then it’s likely to be more tax efficient. Also, how you treat the investment as an investor matters too. Try your best to hold onto investments for long periods of time. This way, you’ll avoid capital gains tax.

Are All Mutual Funds Tax Efficient on Dividends in Canada?

Mutual funds are not tax efficient on dividends since payment of dividends means more taxes. To relieve yourself of tax burdens, avoid buying into investments with high dividends. Unfortunately, there is no other way around this. There is no such thing as a mutual fund that pays tax free dividends. If you want a passive stream of income, you will have to eat the tax bill!

Are All Mutual Funds Tax Efficient on Foreign Dividends in Canada?

Foreign dividends are taxable income like other dividends and sources of investment income. For this reason, if you receive a foreign dividend from a mutual fund, you will still have to pay tax on it. There are no features of a mutual fund that allow investors to bypass this, unfortunately.

Related Reading: Best RRSP Mutual Funds in Canada

How Can I Invest to Avoid Taxes in Canada?

As we saw above, tax efficient mutual funds in Canada are those with low or no dividend payouts. You will also avoid tax by holding onto investments for a long time, rather than selling them in the short term. However, this only applies in non-registered investment accounts.

Beyond this, be sure to utilize your Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP), First-Home Savings Account (FHSA) and other registered accounts available to you. These accounts allow you to invest on a tax-sheltered basis, including on mutual fund investments. This means all dividend and capital gains income earned within these accounts is free from tax. Once you’ve maxed contributions to these accounts, you can begin investing in non-registered accounts. This is where tax efficient mutual funds in Canada come into play!

At a grander level, avoiding taxes is all about understanding the laws and changing your financial habits to minimize your burden. When it comes to tax, it’s best to think about the tax implications before you move forward with a financial decision. Once a transaction or series of transactions occurs, the tax implications cannot be reversed — which can be an expensive lesson. Through practice, you’ll be able to manage your financial habits in such a way that helps you avoid tax.

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