Segregated Funds vs Mutual Funds: It Makes A Difference at Year-End

Walter Harder

At year-end, planning to make investments in non-registered accounts should be peppered with tax-efficiency, especially when it comes to buying mutual funds. Here’s a primer on what you need to know if you are interested in maximizing tax, retirement and estate planning goals.

Mutual funds and segregated funds have a lot of similarities. In both, the fund sells units to investors and uses the proceeds to earn investment income – which is then distributed to the unitholders. Mutual funds may be run by a trust or a corporation whereas segregated funds are operated by an insurance company.

1. Death benefits. Segregated funds may include a death benefit upon death of the investor. This benefit is paid to the named beneficiaries of the fund. The amount of the death benefit may be a guaranteed amount, or the value of the units held when the investor dies. Since the proceeds are paid directly to the beneficiary, they bypass the estate and are not subject to probate. That’s a big benefit in the case of more substantive or complicated estates.

The difference between the cost of the fund units and the amount paid at death is taxed as a capital gain on the deceased investor’s final return. This could put some stress on the estate if there are not enough liquid assets in the estate to pay the taxes on the increase in value of the fund units. Some insurance planning for that eventuality can be important to shore up estate values.

At the death of a mutual fund investor, the units are deemed disposed of for their fair market value, and any increase in value of the funds is taxable as a capital gain on the deceased investor’s final return. The value of the units becomes part of the estate and is subject to probate fees.

2. Segregated funds may offer a guarantee. Usually the funds offer a guarantee that the value of the fund units will not decrease below 75% (or 100%) of the amount invested. This guarantee is usually based on holding the units for a specified period (often 10 years) or until the investor dies. The fund may also offer a reset to investors so any increase in value of the fund units will be guaranteed after the reset. Again, the units must be held for a specific time period in order to take advantage of the guaranteed reset value. Mutual funds do not offer a similar guarantee.

3. Creditor protection. Investments in segregated funds may be protected from creditors or lawsuits if a family member has been named beneficiary of the units. Mutual funds offer no such protection.

4. Loss allocations. Segregated funds that lose money may allocate the losses to investors. Mutual funds with capital losses in one year must have capital gains in a subsequent year to offset the capital losses.

5. Receiving distributions at year-end. While both types of funds allocate income to unitholders at year-end, mutual funds distribute the earnings, either in cash or through re-investment in additional unit in the fund. Segregated fund do not distribute allocated income but retain the earnings in the fund. This means that the value of individual units in a mutual fund decreases at the time of distribution whereas the value of segregated fund units does not change when income is allocated.

6. Timing of Purchases.  While the investor is better off purchasing unit immediately after the annual distribution, whether investing in a mutual fund or a segregated fund, investors in mutual fund units will find that the cost of the unit in a mutual fund decreases immediately after the distribution whereas segregated fund unit prices remain unchanged as a result of the annual distribution.

These benefits come at a price though. The management fees of segregated funds are often higher than on mutual funds. The result is generally lower returns on segregated funds than on similar mutual funds. Also, in order to offer the guarantees, mutual funds often invest in lower-risk assets, often leading to lower investment returns.

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