February 7th, 2017

How mutual funds are taxed

Keeping an investor’s tax bill low can mean higher effective returns

While tax considerations should never dictate an investor’s choice of mutual funds, they are still an important part of the selection process. Understanding how different types of mutual funds are taxed can help investors minimize their tax bills and, in so doing, maximize how much of their investment returns they keep.

Types of investment tax

These four common types of investment income are each taxed in a specific way:

Interest income is taxed as earned at the investor’s marginal tax rate.

Dividends from Canadian sources are taxed as earned and subject to special rules relating to the dividend tax credit, which reduces tax payable.

Dividends from foreign sources are taxed as earned at the investor’s marginal tax rate.

Capital gains are taxed when realized, with 50% of the realized capital gain taxed at the investor’s marginal tax rate.


Mutual funds will typically distribute to unitholders the income they earn from the securities in their portfolio. Interest income and dividends may be distributed monthly or quarterly and net capital gains (if applicable from buying and selling underlying securities) are usually distributed annually. Investors have no influence over the size and timing of fund distributions; these distributions depend largely on how the fund is managed, which is the responsibility of the portfolio manager. This means the investor has no ability to prevent distributions to defer tax. However, investors can choose funds that meet their investment objectives.

Regular dividend or income distributions can be beneficial to investors who need income in retirement to cover essential expenses and lifestyle spending. Investors who are working and investing for retirement generally have no use for distributions. These individuals may be best served by choosing mutual funds that generate minimal income.

Some distributions are characterised as returns of capital. This is a tax-efficient way to meet the needs of retired investors because:

  • they do not trigger the immediate payment of tax; and
  • they are ultimately taxed as a capital gain (or they reduce a capital loss) when investors redeem their units.

Capital gains

Unlike distributions, investors can control when they trigger capital gains or losses by controlling the timing of when they redeem units of a mutual fund. The unit price at redemption relative to its cost price will determine whether the investor is in a capital gain or loss position.

In general, it is preferable to defer the payment of tax on capital gains as long as possible. This is because the money that would have been used to pay tax can be invested in the interim to generate additional returns.

Ranking priorities

Tax-efficiency should be a key consideration for most investors, but it’s important not to let the tax tail wag the investment dog. The investor’s time horizon, financial goals, personal situation and risk tolerance should be the main factors that shape mutual fund choices.

For more information on how mutual funds are taxed, register for IFSE’s course on tax-efficient investing.