The Scoop on Return of Capital

What is Return of Capital?

Distributions from an mutual fund may contain capital gains, dividends, interest income and return of capital. A return of capital is any distribution from a mutual fund that is not treated as either capital gains, dividends, or interest income. These funds are commonly referred to as TSWPs or T-series.

When you receive a return of capital, you are essentially getting back some of your investment.

What is the benefit of Return of Capital?

As a tax deferral device, ROC distributions can be an effective way to defer taxation of investment income.

For example:

1. More cash available today
2. Higher after tax returns on investment income
3. Lower your tax bracket in retirement
4. The ability to defer tax to cheaper dollars in the future
5. More control over when you take capital gains

Good Thing or Bad Thing?

Answer is....depends.

Return of capital cannot be confused with erosion of capital. In other words it is your own after tax money that is actually being paid back to you. This puts the investor in the drivers seat as to when and how he receives their income and pay their capital gains.

However, consider the fact that in down markets an ROC can reduce the capital of the original investment and in up markets the income can be considered a return of growth. The longer a unit is held the better the tax deferral can be.

The investment selections should be conservative and flexible enough to weather ups and downs in the market. As well, depending on the strategy consistency in the income should be there. Fund companies have the ability to change the distribution at their discretion. However, investors will have the opportunity to reinvest a percentage should there be a dramatic increase.

Borrowing to Invest

The popularity of borrowing to invest in ROC funds has increased over the past two years. This can be a gray area for regulators. Investors should be careful not to depend on ROC income to fund an investment loan payment. While this can be looked at as an excellent tool for tax savings, this is not a prudent way to look at servicing an investment loan.

Risks involved in leverage programs should be closely examined in each individual case. Cash flow should there in every situation to finance you loan even without the ROC income.

Strategies

ROC income is an essential component for creating 'Tax Deductible Mortgages' or 'Money Filter' programs. When you properly this can be an effective tool to lowering your taxes while you reduce your debts. Not only that but ROC can create a compounding effect over the long term whereby you can greatly increase your tax returns on a year by year basis.

As we move ahead in our understanding of how these funds can be used at any age we will see a growing popularity of programs utilizing the benefits of these funds.

The key to any investment strategy must have three components:

1. Be conservative based on your personal risk tolerance
2. Educate yourself on every investment choice you make
3. Think long term

Those are the key elements to using ROC wisely.