It’s true that the majority of Canadians now face tax in provinces where the highest marginal tax rates are in excess of 50 per cent. Any time the government has a right to keep more of a dollar earned than the person earning that dollar, one has to wonder how much tax cheating is going on. It reminds me of a comment made by British comedian David Mitchell: “I’m not cheating on my taxes. But if I were, I would cheat and then I would lie about it. But I’m not cheating. Which is what I would say if I were cheating. But I’m not. Which is what I would say if I were.”
The good news is that you can take steps to reduce your tax burden without having to cheat. Given where tax rates are today, it’s worth focusing some time on your investment portfolio. You may be surprised at the difference taxes can make on your returns, and how this can affect your financial well-being over time.
When it comes to creating a tax-smart portfolio, one of the most important questions to ask is this: Is your “alpha” big enough to cover your taxes? Let me explain. “Alpha” can be defined as the added returns provided by your money manager over and above what the market itself will provide. If the market provides a 6-per-cent return over time, and your money manager earns you 7.5 per cent net of fees over that same period at the same level of risk, then your money manager can be said to have provided added value, or alpha, of 1.5 per cent (I’m simplifying things here). If your money manager can’t add value over what the market provides, you’d be just as well off to invest passively in exchange-traded funds (ETFs) where the fees are lower.
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If your money manager is going to buy and sell securities in your portfolio, there could be taxes to pay on dispositions along the way. The alpha added by your money manager needs to be high enough to make up for any taxes created when securities are sold.
As an example, suppose you have $100,000 to invest and can earn 6 per cent in capital growth annually. At the end of 20 years, that portfolio would be worth about $320,700 assuming no taxable dispositions over that time. But suppose that 30 per cent of your portfolio is turned over (sold and reinvested) annually in a non-registered portfolio where taxes matter. In this case, that same portfolio would be worth $292,800, or 8.7 per cent less at the end of 20 years, if you’re in the highest tax bracket in Ontario. You’d have to earn an additional 0.52 per cent on your portfolio annually in this 30-per cent turnover example to end up with the same $320,700 after 20 years.
This may not seem like a lot of additional alpha that you’ll require, but it’s important to realize that many money managers turn over their portfolios much more than 30 per cent annually, which increases the additional alpha “hurdle” they need to earn.
Further, consider a portfolio in a taxable account that earns half of its returns from interest income. The $100,000 portfolio example above earned all capital growth. If we change the mix of investments so that half the returns are highly taxed interest (to get 6 per cent on interest-bearing investments today, you’d likely be in private mortgages or something similar, but I want to make the point about the impact of taxes, so follow me here), the value of that portfolio would be just $225,650 at the end of 20 years, or 29.7 per cent less than the tax-efficient portfolio that amounted to $320,700. In this case, you’d have to earn an additional 2.67 per cent annually on the taxable balanced portfolio to end up with the same $320,700 at the end of 20 years (albeit the risk profile of these portfolios is very different).
There are two key drivers, then, that will affect the taxes paid on your portfolio, and therefore the level of assets you can accumulate over time. The first driver is portfolio turnover. Today, just 50 per cent of realized capital gains are subject to tax in Canada, which mitigates the harm that portfolio turnover might have, but it still makes a meaningful difference. The second driver is portfolio make-up, which dictates how much interest, Canadian dividends and capital gains you generate. Each of these types of income is taxed differently and will result in very different portfolio values over time when investing outside of registered plans. More on this next time.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at firstname.lastname@example.org.