When you invest in a mutual fund, you may get a distribution that includes a return of capital. This typically happens in funds with fixed monthly distributions.
A return of capital distribution represents a portion of your initial investment being returned to you.
In this video, we’ll answer three key questions about return of capital.
When the income generated by a fund is less than the fund's target payout level, return of capital fills the gap. This helps smooth out distributions and provides consistent monthly cash flow.
Return of capital distributions are tax efficient since they are not taxed in the year you receive them.
For example, if you receive a $100 return of capital distribution this year, that money isn’t taxed. It does, however, affect your tax picture when you later sell the fund.
The amount you receive as a return of capital is deducted from your adjusted cost base, or ACB.
Think of the ACB as the total amount you have paid for your investment. This includes your initial investment and all your contributions and withdrawals.
Return of capital reduces your ACB. If your ACB is $1,000 and you receive a return of capital distribution of $100, your ACB will drop to $900.
Over time, return of capital distributions will continue to reduce your ACB. When you decide to sell your investment, this lower ACB may increase your capital gain or reduce your capital loss.
Sticking with our example, let’s say your fund is valued at $1,200 when you sell it. $1,200 minus $900 means you have a capital gain of $300.
This capital gain may be higher than it would have been without the return of capital distribution. But remember you’ve taken that $100 as cash flow and been able to spend it tax-deferred until you sell the fund, which may be many years later.
There are three main benefits of receiving return of capital as part of your monthly distribution.
- It helps provide steady cash flow by augmenting the income earned by the investments within your mutual fund.
- It increases the tax efficiency of your cash flow.
- It helps you defer tax payments until you sell your fund. This provides added control over tax payments.
And there may be specific situations where return of capital is especially valuable.
When you retire, ROC distributions may help if your income is approaching the income-tested limit for a government benefit like old age security. This could help you preserve more of your government benefit.
By investing in a solution that distributes return of capital, you may be able to reduce your annual taxable income, while maintaining your cash flow.
For more information about ROC please speak to your advisor.