Mutual fund distributions and segregated fund allocations may at first appear to be similar. However, when compared directly, the differences between the two are more nuanced than one would expect.
Structure
Mutual funds are commonly structured as trusts while segregated funds are insurance contracts issued by life insurance companies and are deemed as trusts for income tax purposes. These funds are similar as they both allow investors to pool their money and invest in a diversified portfolio of securities. Mutual funds are attractive to many investors due to their simplicity, while segregated funds offer additional features, such as guarantees that protect the original investment and flexibility in estate planning.
Allocation versus distribution
A key distinction between a mutual fund and a segregated fund is how income and losses from the funds are treated in the investor’s hands. A mutual fund “distributes” its income to the unitholder, while a segregated fund policy “allocates” its income to the policyholder. Let’s look at what that means.
Distributions by a mutual fund trust
A mutual fund would generally distribute taxable income and realized capital gains to its unitholders. Otherwise, undistributed income in the mutual fund trust would be taxed at the highest individual marginal tax rate. Mutual fund trusts may distribute capital gains net of capital losses, but not losses net of gains; a net loss would be held within the fund and offset against gains in future years.
Distributions are generally made once a year in the form of cash or reinvested units, on a distribution date to unitholders on record of owning the fund when declared. Income distributed maintains its character (e.g., interest, dividends or capital gains) based on the type of income earned by the trust.
The income and gains are reported on a T3 tax slip (plus a Relevé 16 in Quebec) and, if reinvested, added to the adjusted cost base (“ACB”) of the investor’s holdings. The reinvested units have a cost equal to the amount distributed. The calculation of the ACB is the unitholder’s responsibility.
Total fund assets decline by the distribution amount, so the per-unit net asset value also declines.
Allocations by a segregated fund policy
A segregated fund is deemed as a trust for income tax purposes and similarly, taxable income and realized capital gains, losses or both would be taxed in the policyholder’s hands.
Allocations are generally made once a year and the income allocated maintains its character (e.g., interest, dividends or capital gains or losses) based on the type of income earned by the fund. Most segregated fund policies sold by Canada Life use a time-weighted method of allocation. The income is allocated to the policyholder based on how many notional units and how long they were invested in the segregated fund policy.
There are some nuances with capital gains and losses. For most segregated fund policies sold by Canada Life, if there are no fund redemptions in the year, all the gains will be allocated to the investors. When there are redemptions, the fund gains will be allocated first to investors who redeemed fund units. Any remaining gains or losses will be allocated to the other remaining investors. One key difference from mutual funds is net capital losses can flow through to the investor’s hands, as opposed to being retained at the fund level.
Any income allocation and realized gains or losses (from fund manager or policyholder activity) are reported on a T3 tax slip (plus a Relevé 16 in Quebec) and are added to the ACB of the investor’s holdings. The insurance company tracks the policy’s ACB for calculating respective capital gains or losses.
When income is allocated by a fund, the actual income is retained within the fund. No additional units are purchased, and the fund’s unit value is not reduced. Allocations cannot be paid in cash like distributions. A request for a partial withdrawal must be made.
Fund performance: a common misconception
A common misconception compares the allocation or distribution to the performance of a particular fund. In fact, the allocation or distribution has no correlation to the performance of the fund.
If the fund does not have any income to allocate, it does not mean the fund is performing poorly. For example, many equity funds and growth-oriented funds, in particular, appreciate in value due to increases in the value of the underlying investments. Any increase in the fund-owned asset value is not included in the fund’s taxable income until the asset is sold.
All components of a fund performance need to be considered rather than just comparing the allocation or distribution of the fund.
Registered account
Allocations or distributions made to a registered plan are not immediately taxable and tax slips are not issued. Generally, registered funds are taxable once withdrawn from the account, except in the case of a Tax-Free Savings Account (TFSA) which has the advantage of both tax-free growth and withdrawals.