The Globe and Mail

My son Win never ceases to amaze me with his knowledge. He's 10 years old now. This week, as we were driving home from his hockey practice, he was sipping a Gatorade and declared authoritatively: “Dad, you probably didn't know this, but the Queen doesn't drink Gatorade.”

“Oh, really?” I replied. “How do you know that?”

“I dunno. I just know,” he replied.

“Well, I happen to know that the Queen is in strict training to compete in pole vaulting at the next Olympics, so I bet she does consume some kind of recovery drink – maybe a branch-chain amino acid enhancer of some kind.” Win was skeptical. He debated me on that.

So, I turned the conversation to tax planning and investing. “I know a way to save taxes and produce pretty high guaranteed rates of return at the same time.”

This time, it was my wife Carolyn that was skeptical. She debated me on that. Just to prove it's possible, let me share my thinking.

Tax Savings

If you look really hard, my guess is that you'll find one or two losers in your investment portfolio today. I'm not talking about poor-quality investments necessarily, but investments that have declined in value since you bought them.

As we approach the end of the year, selling some of these investments can make sense if you have taxable capital gains that you realized this year, or in one of the three prior years (2007, 2006 or 2005). The capital losses that you'll realize by selling some of these losers can be applied against the capital gains, and you'll either avoid tax on those capital gains that might have been realized in 2008, or you may recover taxes that you might have paid in a prior year on those capital gains (capital losses can be carried back up to three years by filing Form T1A with your tax return next spring). It'll soften the blow of declining investment values.

And let's face it, you may be thinking of moving some of your portfolio into cash anyway, given the volatility in the markets today. If you do this, be sure to consider selling sufficient losers to offset the capital gains on the sale of any winners. And if you do move into cash, you may realize tax savings from the capital losses, but this begs the question: What should you do with that cash?

Higher Returns

I'm going to suggest that you pay down some debt with any cash you might free up from the sale of investments today. Earlier this year, I wrote about the value of this strategy (April 3, 2008), which effectively provides a guaranteed after-tax rate of return. How much is that rate of return? Simple: It equals the after-tax interest costs you'll save from eliminating the debt.

If, for example, you borrow at 7 per cent, and you can deduct your interest, your after-tax interest cost is just 4.55 per cent, assuming a 35-per-cent marginal tax rate. Your risk-free rate of return, then, would be 4.55 per cent if you paid off that debt. If you're not able to deduct your interest costs, then your risk-free rate of return in this case would be 7 per cent – the actual interest rate on your loan. Where else can you achieve a risk-free, after-tax return of 7 per cent?

Hey, if you can earn more than 4.55 per cent after tax from your portfolio, then it might make sense to invest cash instead of paying down debt, but many would say that's a tall order. You should realize that to achieve a 4.55 per cent after-tax return, your pretax hurdle rate of return would have to be 5.52 per cent if you expect to earn capital gains. If you expect to earn interest income, you'd have to earn 7 per cent before taxes to be left with 4.55 per cent after taxes (assuming a marginal tax rate of 35 per cent; the hurdle rate is even higher if you're marginal tax rate is higher).

And don't forget, if your interest cost is not deductible for tax purposes, your hurdle rate becomes 7 per cent in my example – the actual interest rate on the debt. You'd have to earn 8.5 per cent before taxes if earning capital gains, and 10.78 per cent before taxes if earning interest income. Good luck.

The fact is, selling losers and using the cash to pay down debt will produce higher risk-free, after-tax returns than most investors will expect to earn on a portfolio in the short term.