Investing in an After-tax World
Today’s media is full of advice for the retail investor. At least 99% of that advice relates to before-tax investment returns. It ignores the fact that we all live in an after-tax world.
In part, this is because people find thinking about investing and tax planning at the same time to be much like patting their head and rubbing their stomach – surprisingly difficult.
When a tax issue is raised with an investment advisor, the ill-considered response is often, “Don’t let the tax tail wag the investment dog.” In fact, maximizing investment returns and minimizing taxes are, more often than not, entirely compatible goals.
Consider two simple examples. All studies have shown that, over time, stocks are likely to produce a higher before-tax investment return than bonds; and the return from stocks (dividends and capital gains) is taxed at a lower rate than interest from bonds. Also, low-fee index funds or ETFs have been proven to beat 80% of actively managed retail mutual funds over time. And, because the lower turnover within the index products defers the payment of capital gains tax, these index products are also more tax efficient.
But let’s assume that you, like most people, have elected to use an active investment manager, a financial planner or a traditional stock broker as your financial advisor. Your instructions are that the selection of securities is to be made with a view to maximizing your before-tax investment return. Should you also expect your advisor to minimize the tax that you pay on your investments? Absolutely you should! A knowledgeable advisor who puts your interest first will take the time to allocate your securities among your accounts in the most tax efficient fashion. This will have a major effect on the amount of capital you will have, to live on, in your retirement.
To illustrate, imagine you have a total portfolio of $1 million, of which $490,000 is in an RRSP account, $490,000 is in a nonregistered (i.e. taxable) account and $20,000 is in a Tax Free Savings Account (TFSA). Your portfolio consists of Canadian and U.S stocks, most of which pay a dividend.
Most of your U.S. stocks are paying you dividends that, if held in a taxable account, would be taxed at your highest marginal tax rate. To the extent possible, these stocks should be held in your RRSP. If you do this, not only are the U.S. dividends not currently taxable, but under the Canada-U.S. Tax Treaty there is no withholding tax levied by the U.S. government on the dividends.
Most of your Canadian stocks pay a dividend. On these Canadian dividends you get a dividend tax credit, which, if held in a taxable account, can result in anything from no tax to a tax rate well below your top marginal rate. So, to the extent possible, these stocks can be held in your non-registered account.
Your TFSA shelters from tax the income and capital gains relating to securities held in the TFSA. However, dividend paying U.S. stocks should not be held in a TFSA account as one can never recapture in a TFSA the otherwise refundable withholding tax paid on U.S. dividends. High dividend paying Canadian stocks are a better choice.
And what about those shares of Berkshire Hathaway that you bought 10 years ago and expect to hold for the long run? Because Berkshire does not pay a dividend, and this will likely be a long term hold, you can achieve a major tax deferral simply by holding your Berkshire shares in your taxable account. They should not be held in your RRSP account because that would have the effect, when you cash in your RRSP, of converting the low tax rate on the realization of a capital gain to your then top marginal tax rate.
Because you live in an after-tax world, your objective should be a high after-tax investment return. Accomplishing this objective involves both maximizing your before-tax return and minimizing the tax you pay on that return.
Reaching the before-tax investment return goal is necessarily a probabilistic exercise. There are no guarantees. There is far more certainty surrounding your ability to improve your after-tax return by intelligently allocating investments among accounts. A good investment firm will do this for you.