Ever increasing numbers of Canadians are considering switching from high cost mutual funds to lower cost investment alternatives. But what about capital gains tax if those funds are held in non-registered accounts (i.e. outside TFSAs, RRSPs, RRIFs, RESPs, etc.)? Will the tax hit wipe out the benefits of lower ongoing costs? Often, the answer is no. The benefits of switching can significantly exceed the impact of capital gains tax.

Consider the following example:

Assume you invested $200,000 in a balanced mutual fund 10 years ago through your non-registered account. Despite 2.25% in annual fees (MER) embedded in the fund, strong market gains have brought the total value of your investment to $300,000. You want to reduce your costs by switching to a low cost “all-in-one” balanced ETF which charges 0.25% in fees for an annual fee reduction of 2%. Will switching be worth it?

Selling the mutual fund would trigger your $100,000 gain, 50% of which would be taxed. Assuming your marginal tax rate is 40%, your tax bill would be $20,000 leaving you only $280,000 to invest in ETFs. It may seem at first glance that this cost is much greater than any fee savings. But remember that capital gains tax would have to be paid eventually. Sale of the mutual fund just accelerates the timing of the $20,000 tax liability.

Let’s make the assumption that the balanced mutual fund and the balanced ETF both generate an average annual return of 6.25% before fees going forward. In that case, the mutual fund would generate an annual return of 4% after fees while the ETF would produce a 6% return after fees. If you keep the mutual fund you will earn 4% or $12,000 over the next year on $300,000 invested. However, if you make the switch, you will earn 6% on your $280,000 invested for a first year pre-tax gain $16,800. Despite the reduced investment amount, your return is $4,800 greater.

Your surplus gain grows every year and becomes a very large amount over time especially if you allow the gains to compound. And if you make the switch, your capital gains tax when you ultimately sell will be reduced because you already paid the $20,000 in tax when you switched. So, in this scenario, all other things remaining equal, it makes total sense to switch.

Sometimes individual tax circumstances are very complex. If you need tax advice, get it from a tax professional.  While the math is a bit more complicated than I have demonstrated above you can do your own rough cost/benefit analysis as follows:

  1. Determine your approximate capital gain
  2. Determine your marginal tax rate (try this handy PWC calculator)
  3. Calculate your approximate tax payable if you switch
  4. Assume rates of return before and after fees on your existing asset and potential new asset
  5. Determine projected first year dollar returns on your existing asset and the potential new asset

 

Here are a couple of additional examples:

 

Ken holds a number of mutual funds with a current market value of $200,000 with annual embedded costs (MER) of 2%. His original cost was $150,000. He is considering switching to a robo-advisor with a total annual cost of 0.7%

  1. Gain is $50,000
  2. Taxable gain is $25,000
  3. Ken’s marginal tax rate is 35%
  4. Ken will owe $8,750 in tax if he switches
  5. Ken assumes both his mutual funds and robo advisor will generate 7% p.a. before fees which means that after fees the mutual funds will produce 5% and the robo-advisor will produce 6.30%
  6. Ken’s $200,000 mutual fund will produce a return of $10,000 while $191,250 invested through the robo-advisor will produce $12,048.75

 

 

Tanya holds mutual funds with a current market value of $1,000,000 with combined annual advisory fees and embedded costs (MER) of 1.60%. Her original cost was $800,000. She is considering switching to low cost ETFs with a total annual cost of 0.20%

  1. Gain is $200,000
  2. Taxable gain is $100,000
  3. Tanya’s marginal tax rate is 50%
  4. Tanya will owe $50,000 in tax if she switches
  5. Tanya assumes both the mutual funds and ETFs will generate 5% p.a. before fees which means that after fees the mutual funds will produce 3.40% and the ETFs will produce 4.80%
  6. Tanya’s $1,000,000 mutual fund will produce a return of $34,000 while $950,000 invested in ETFs will produce $45,600

 

If Ken and Tanya switch and allow their gains to compound, their advantages will increase. And their eventual capital gains tax bills will be lower because they already paid tax when they switched.

I hope this explanation and the examples are helpful to those of you considering getting rid of high cost mutual funds in non-registered accounts.

 

Larry