1% in your pocket is better than 1% in the taxman’s pocket


We often tell clients that while you can’t always control investment returns, you can be tax smart in terms of how you invest. If you can add 1% after tax a year to whatever your investments happen to return, you will be much better off over time.

Very roughly, if you are in Ontario and in the tax bracket over $136,000 of income, you will lose almost half of your gains on GICs, bond interest, and U.S. stock dividends. If instead you bought a preferred share or Canadian stock that pays a dividend, you will lose about 30% to taxes. If your investment gains come from capital gains, you will lose a little less than a quarter to taxes.

In Canada, we have many investment accounts that are tax sheltered. This means that on an annual basis, we don’t need to worry about the interest, dividend or capital gains earned on these investments. Money that is invested in RRSPs, RRIFs, TFSAs, LIRAs, LIFs, RESPs and RDSPs, have no tax charged on their annual growth.

There are still tax considerations for most of these accounts relating to the taxation of withdrawals, but for this article we will focus on taxable or non-registered investment accounts – because this is where the secret of the 1% lies. If you have an income over $136,000 in Canada, and live in Ontario, the numbers work this way:

• Earn 5% interest on a GIC, get taxed at 46%, after tax you earn 2.7%.

• Earn 5% in dividends on BCE stock, get taxed at 29.5%, after tax you earn 3.5%.

• Earn 5% from a capital gain on the price growth of a stock, get taxed at 23%, after tax you earn 3.8%

On the same 5% investment gain, you can keep an extra 1% if the gains are in a mixture of capital growth and Canadian dividends than if they come from interest income. Of interest, the extra 1% happens almost regardless of your income and the province you live in.

It is important to remember that risk tolerance certainly plays a role here.  A GIC or Bond may be less tax efficient, but will certainly have less downside risk than a stock.  The key here is that there are ways to maintain your overall investment risk across all accounts, while adjusting things in your taxable account to leave you with more money in your pocket after tax.

Let’s take a look at Royal Bank. You could invest in several ways related to Royal Bank. Let’s take $100,000 and put it in a one year GIC at Royal Bank in a taxable account. You will get a rate of about 1.30% for a 1-year locked-in GIC. You will end up with $101,300 when it comes due. But then the taxman will take almost half, leaving you with $100,697.
You weren’t too happy with those numbers, so instead you decided to put it all in Royal Bank stock on Jan. 1, 2013. It was a good year for the stock, rising 19.25% in price and roughly another 4% from dividends for a total gain of 23.25%. Unfortunately, you have to pay taxes here too. If we assume that the stock was sold at the end of the year, you would have to pay capital gains tax on the 19.25% price gain, and regardless of a sale, you would have to pay dividend tax on the 4% in dividends earned. After tax, the 23.25% gains end up at 17.6%. About a quarter of the gains get charged to taxes. Still a very good return, sitting at $117,600.

What if you bought a Royal Bank bond? Last January you could have purchased a Royal Bank bond that comes due on March 30, 2018. The coupon payment was 3.77%. The bond was bought at a price of $107.50 and sold at year end for $105.00. While technically not correct, let’s assume that you earned 3.77% in bond interest during the year on this purchase. You also lost 2.3% on the capital loss. From a tax perspective, the $2,300 loss on the bond will help you. You can use it to offset other capital gains this year. If not enough other gains this year, you can use it against capital gains from the past three years or for any eventual future capital gains. On the $3,770 in bond interest, it is taxed just like the GIC income. After tax you are left with $2,021 from the bond interest. After tax, you have $99,721 plus a capital loss that you can use.

The last Royal Bank investment was to buy a preferred share. Let’s say we bought the E series Royal Bank preferred for $26.00 last January. It was sold for $25.40 at year end for a loss of 2.3%. The good news is that it pays a dividend of 4.40%. So for this investment we lost $2,300 on the capital loss and made $4,400 on the dividend. Just like the bond, the capital loss will help us, but not necessarily lower our taxes this year. The $4,400 of dividends is taxed at just under 30% just like the dividend on the ‘regular’ or common stock. After tax the dividend is still about $3,100, leaving a total balance after tax of $100,800 plus the use of the capital loss.

If we look at these four different investments, on the pure investment before tax, we see that the common stock earned 23.25%, and the preferred share made 2.1%, the bond earned 1.47%, and the GIC made 1.3%.

When we look at it after tax, the order is almost the same, but the earnings change.

Common stock 17.6%, preferred share 0.8% but also capital losses worth over $500 after tax. The GIC was up 0.7% and the bond lost 0.3% but also has the capital loss to use.

In my view, the lesson here is that each investment will provide different investment returns each year, but because of the high rate of tax on interest income, bonds and GICs should usually be avoided in taxable investment accounts. Here is where preferred shares can be used for lower volatility, and common stock (especially Canadian) has significant tax advantages. If this focus on common shares and preferred shares makes your overall portfolio too risky, you can use the other tax sheltered accounts in your portfolio to balance off your overall risk.

For those with taxable investments, get your extra 1% every year, and in the long run, it will add up.

Ted can be reached at tedr@tridelta.ca or by phone at 416-733-3292 x221 or 1-888-816-8927 x221

Reproduced from the National Post newspaper article 21st April 2014.