High net worth investors are keen on tax efficiency in their investments. Understandably so, since taxes have a huge impact on investment returns.
Mutual funds are sometimes seen as least tax efficient, because of their distributions to unitholders, which can be taxed as income, dividends, or capital gains—sometimes all three. However, some mutual funds use what’s called the Capital Gain Refund Mechanism (CGRM) to reduce or eliminate the tax hit on unitholders. How does this work and are there any other tax-efficient strategies available?
Firstly, the best way to shelter mutual fund gains from tax is through a tax-free savings account (TFSA). Fund distributions, investment income, dividends, and capital gains within a TFSA are not subject to tax, either while inside the plan or on withdrawal. The only real drawback for TFSAs is the relatively low annual contribution limit, currently $5,500. However, high net worth investors will use this, and any previous contribution room, fairly quickly.
A registered retirement saving plan (RRSP) has a higher contribution limit, and unused contribution room can add up pretty quickly. Contributions are eligible for a tax deduction. Investments in the plan grow on a tax-deferred basis and are subject to tax at your top marginal rate only at the time of withdrawal (usually at retirement, when your top marginal tax rate is expected to be lower than in your peak earning years).
