Segregated Funds give you A Tax Advantage

It is widely known that segfunds offer advantages over mutual funds in terms of maturity and mortality guarantees and creditor protection.

But, another feature that is less publicized is a tax advantage: if a segregated fund loses capital in a given year, the unitholders can claim the capital loss on their taxes and offset any capital gains made on other investments. Mutual fund investors cannot do this.

The reason behind this is that while taxation rules permit seg funds to allocate out gains and losses, mutual fund companies do not have the ability to allocate - they distribute gains or losses. Distributing and allocating are two different things.

With distribution, you must physically distribute the dollars out and you can't physically distribute a loss. If a person invests $1000 in a seg fund and it's worth $900 by the end of the year, he or she can receive a T3 form showing negative $100. This can be used to offset a capital gain on another investment.

In the same situation, a mutual fund holder could not declare the loss unless he had already cashed it in.

TAX EFFICIENCY AND SEGFUNDS

The mutual fund advertisements talk of higher and higher yields, and try to sell you on often short-term performance. While high performance is obviously important, it is the volatility of the longer-term performance that tells a more useful story at  times.

And for non-registered investments, how much of that growth is reportable as income each year is perhaps even more important, since it is the after-tax performance that ultimately counts. "Tax Efficiency" refers to the proportion of an investment's annual growth that is not subject to annual taxation. It also incorporates the effective tax rates for various types of income, to produce a measure of how much growth you actually keep.

For instance, a bank account that produces interest income is only 50% efficient, assuming a 50% marginal tax rate, since every cent of income is reportable each year, and that income receives no preferential tax treatment. Conversely, funds that generate dividend income rather than interest or capital gains income will tend to be more tax efficient, since dividends are taxed at 36% and capital gains 39% assuming a top marginal rate and 50% provincial rate.

In general, a "buy and hold" strategy will improve the tax efficiency of any fund, since a significant portion of the fund growth is in the form of unrealized capital gains - i.e., paper profits that would only be reportable if the fund manager sold the underlying securities. However in certain funds or market conditions a buy and sell strategy may not be best.  This is when segfunds with their alternative tax treatment can provide you with an extra benefit.