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OBJECTIVE

“Tax-efficient investing: principles, pitfalls and applications” is eligible for CE credits, see Accreditation details for more information

While tax-advantaged vehicles such as RRSPs and TSFAs are a sure bet for most investors, they are limited by the investor’s contribution room. Once that has been exhausted, investing in taxable accounts is the next step. At that point, it becomes necessary to take tax considerations into account.

Taxes can have a major impact on investment returns. While few statistics are available in Canada, U.S. studies show that in the ten-year period from 1999 to 2008, taxes reduced the annual return of equity mutual funds by an average of 1.13 percentage points. Bond funds fared even worse because taxes lopped an average of 2.13 percentage points off their annual return.

Why does this matter? Investors typically save for their retirement over long periods of time. Through compounding, a difference of one or two percentage points in the annual return may mean the difference between a comfortable retirement and a frugal one. Tax-efficient investing may lessen the tax bite.

PART 1:

PRINCIPLES OF TAX-EFFICIENT INVESTING

Tax-efficient investing is not about minimizing taxes. If that were the objective, it could be achieved very simply by holding investments which generate no return at all. The aim, rather, is to maximize the after-tax return. Tax efficiency is only part of the story. Advisors should recommend products on the basis of their investment merits and their suitability to the client. While tax considerations should form an integral part of the exercise, a recommendation should not be predicated on tax considerations to the exclusion of other relevant factors. The investment dog should wag the tax tail and not the other way round.

Investment returns can take different forms, depending on the nature of the investment. Cash generates interest income. Bonds generate interest income and, to some extent, capital gains. Stocks generate capital gains and dividends.

The most common forms of investment return are:

  1. Interest income
  2. Dividends from Canadian companies
  3. Dividends from foreign companies
  4. Realized capital gains, net of realized capital losses
  5. Unrealized capital gains, net of unrealized capital losses

Each type of return is taxed differently, as shown in Table 1.

Table 1: Tax treatment of investment returns

Type of Return Tax Treatment
Interest income Fully taxed at the investor’s marginal tax rate
Canadian dividend income Subject to gross-up and the dividend tax credit
Foreign dividend income Fully taxed at the investor’s marginal tax rate
Net realized gains 50% is taxed at the investor’s marginal tax rate
Net unrealized gains Not taxable until the gain is realized

Interest and foreign dividend income are taxed as ordinary income. In other words, they are taxed in full at the investor’s marginal tax rate.

Canadian dividend income is subject to separate tax rules, relating to gross-up and the dividend tax credit, which are designed to avoid the double taxation of dividends.

Maximizing capital gains

Capital gains have two relevant characteristics. First, they are more favourably taxed than other types of return, since only 50% of capital gains need to be included in income for tax purposes. Making the most of the favourable treatment of capital gains is an important principle of tax-efficient investing.

Secondly, capital gains are taxed (and capital losses allowed as deductions) only when they are realized, for example, when the related investment is disposed of. As long as the investor continues to hold the investment, tax on the gain is deferred. Since the investor is free to decide when to dispose of the investment, the timing of the payment of tax on capital gains is, to some extent, discretionary.

It is always preferable to pay tax later rather than sooner because the money can be invested during that interval, earning additional returns. The deferral of taxes on capital gains is another important principle of tax-efficient investing.

Implications for asset allocation

Investors’ tax bills depend on the mix of the different types of return they earn on their portfolio. While the lightest burden is borne by investors who earn their return in the form of capital gains—especially if the related taxes are deferred for as long as possible—the biggest impact is on those who earn ordinary income such as interest.

The mix of returns depends to a large extent on the investor’s asset allocation, which is the process of dividing up the portfolio into asset classes such as stocks, bonds and cash. A portfolio with a large allocation to stocks will generate returns mostly in the form of capital gains and dividends. However, one with a large allocation to bonds or cash will generate returns mostly in the form of interest.

Best practice is to perform asset allocation with the use of a computer program known as an optimizer. This tool uses the expected return of each asset class and the related volatilities and correlations to generate efficient portfolios, i.e. portfolios with the least risk for a given expected return. The exercise is usually based on pre-tax numbers.

This approach is fine for tax-exempt investors such as pension funds. For the taxable investor, however, it is the after-tax return that matters, and asset allocation should be performed using after-tax numbers. Because of the favourable tax treatment of capital gains, this will usually result in a larger allocation to stocks when compared with an asset allocation based on pre-tax numbers.