Segregated funds are a combined investment and life insurance product available in Canada. On the other hand, mutual funds are purely investments that you can hold inside or outside your RRSP or TFSA.
What are segregated funds
Segregated funds (also known as seg funds) are both an investment and life insurance product. They are offered by Canadian life insurance companies, some financial institutions and several mutual fund firms.
Why are they called segregated funds? These funds are “segregated” from the life insurance company itself, offering investments in stocks, bonds and other vehicles.
In addition, segregated funds can be a form of life insurance. If you designate a beneficiary of your segregated funds, this person will receive the funds immediately upon your death. The proceeds bypass the estate and are probate-tax free. However, they are subject to income tax and capital gains tax, whether they are held in a registered account (an RRSP or RIF) or a non-registered account.
What is a mutual fund?
Mutual funds allow individual investors to purchase a pool of investments that can hold stocks, bonds and other investments.
Mutual funds can vary widely. They might invest in blue-chip, large companies that provide safe investments but little potential for accelerated growth. Or they might hold small-cap startups with the hope that some of these firms will turn out to be the next Shopify or Apple.
There are no fees to purchase mutual funds. However, the fund will charge a management fee of between 1 and 3 percent to provide professional money managers to select the investments and cover administrative costs.
What’s the difference between a segregated fund and a mutual fund?
Let’s start with the similarities. Both mutual funds and seg funds hold investments in stocks, bonds and other instruments.
There are some important differences. These will have an impact on whether mutual funds or segregated funds are the right choice for you:
- Life insurance: Segregated funds are a form of life insurance – when you die, the money passes directly to your beneficiary. On the other hand, mutual funds are a simple investment. If you die, they are part of your estate and will be placed in probate. Your estate will have to pay tax on mutual fund income before the money can be disbursed to your heirs.
- Guarantees: Mutual funds offer no guarantees. You can lose some or all of your investment if the fund performs poorly. Segregated funds usually offer a guarantee that 75 to 100 percent of the principal will be returned if you hold them to the Maturity Guarantee date, which is typically 10 years.
- Investment types: Both seg funds and mutual funds can be invested conservatively or in higher risk vehicles.
- Liquidity: Both types of funds can be sold at any time.
- Creditor protection: Segregated funds offer creditor protection since they are a form of life insurance. If you are facing bankruptcy, they can’t be seized provided you have named a family member as a beneficiary. Mutual funds offer no such protection.
Segregated fund taxation
Segregated funds can be held within an RRSP or TFSA, so receive the same tax protection. You only pay taxes when the money is withdrawn.
As we have indicated, the major taxation advantage of segregated funds is that they are a life insurance product. As such, your beneficiary receives the funds directly without going through probate.
Segregated fund example
There are different kinds of segregated funds, depending on your goals. For example, Sun Life has three options:
- Investment: Investing your money for long-term growth
- Income: Using your investment to generate lifetime income
- Estate: Upon your death, you may wish to leave funds for your beneficiaries. This fund provides a death benefit of 100 percent of the funds you have deposited or the current value, whichever is greater
Segregated funds advantages
- Principal protection: Unlike mutual funds, segregated funds often offer a guaranteed return of 75 to 100 percent of your investment.
- Taxation: Upon death, your heirs receive the payout directly. They avoid probate taxes but are subjected to income tax and capital gains tax.
Segregated funds disadvantages
- Higher costs: The fees associated with segregated funds are usually higher than for mutual funds. This is to cover the cost of the insurance features.
Mutual fund advantages
- Lower costs: The management expense fees are normally about 1 to 3 percent of your holdings, which is less than segregated funds. Over the long term, reduced management fees can make a huge difference to the growth of your portfolio.
Mutual fund disadvantages
- Higher risk: With segregated funds, you may be guaranteed to get most of your principal back if you hold them until the Guaranteed Maturity date. On the other hand, mutual funds can drop dramatically if the stock market turns bearish or your fund’s managers make poor investment decisions.
- Taxation: When you hold mutual funds in your RRSP or TFSA, your estate will face a tax hit upon your death. With segregated funds, you will avoid probate taxes – but do have to pay income tax and capital gains tax.
Are segregated funds for you?
You will need to make an overall financial plan and decide whether seg funds or mutual funds (or both) are best for you. Consider segregated funds as part of your life insurance plan. If you want to leave an estate to your heirs, some holdings in segregated funds may be worthwhile.
If you decide to purchase segregated funds, be sure to review the contract very carefully. Segregated funds can be complicated so it’s important to be aware of what you (or your beneficiaries) will receive in different situations. With both mutual funds and segregated funds, check what fees are charged – these can have a huge impact on your long-term returns.
