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Tired of rolling the dice?

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If we truly are in a period of low growth and low interest rates for the next several years, how do you invest for income? How much risk do you need to take to get a 5% yield?

The answer is not that much.

Today, many income investors tend to share the following traits:

  • Looking to generate income from their portfolio that will be at least 4%
  • Have no corporate pension
  • Are increasingly focused on capital preservation
  • Understand that 2% GICs/T-Bills are not a good long-term solution
  • Want to be tax efficient

In our discussions with clients, the general comment is that they don’t need a 10% return, they are fine with 5% or 6% returns, but they can’t have a -10% return or worse.

This type of focus leads to some new thinking on portfolio management and investment solutions.

Here is one fact that has supported this new thinking. According to a research study by BlackRock’s Richard Turnill and Stuart Reeve, 90% of U.S. equity returns over the last century have been delivered by dividends and dividend growth.

Turnill and Reeve head the global equity team for the world’s largest money manager. It kind of makes you wonder why you would ever own something that doesn’t pay any income.

Investing for income can be very simple. Only buy what has a big yield.

Sometimes that strategy can actually work, but usually in an environment where you are going from a high level of market jitters towards one of market confidence.

The problem is that big yields are usually a sign of greater risk. Either a company is paying a very high yield because they need to do so to get people to buy it, or what was once a modest yield has become a large yield because the price of the security fell a great amount.

The other problem is that with common stocks in particular, a company can easily cut or eliminate their dividend, and as with Yellow Media last year, you go from having a high yielding security to one with no yield.

I believe in five components that are needed to achieve solid income, with moderate risk:

Bonds – Any bonds with a BBB rating or better (although you can’t ever truly trust the credit agencies). All companies need to be closely analyzed on a free cash flow basis and their existing debt obligations need to be understood. No bonds are to be held with a yield to maturity of less than 2%. Bonds can be traded to adjust duration of the portfolio or to take advantage of lateral improvements in yield to maturity.
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High Interest Cash – Given the low interest rate environment, it makes little sense to hold a ‘risk’ asset like a bond when risk free daily interest bank accounts will pay 1.75%. This cash component is the bedrock of the portfolio, and by having it in place, it allows for some risk in the bond portfolio to achieve a reasonable yield return.

Preferred Shares – These holdings are used primarily for the tax advantage of dividend income in a taxable account. If someone has an income of $75,000, in Ontario they will get taxed at 33% on bond interest, but just 14% on dividends. In Alberta, the number goes from 32% on interest down to 10% on dividends. While not equal in risk to corporate bonds, they are close, especially if there is some form of redemption or rate reset feature. In some cases today, the yield on preferred shares is meaningfully higher than bonds with similar risks.

Stocks – The goal is to hold dividend “payers” and dividend “growers”, and to do the work necessary to identify companies at risk of dividend cuts, very early on. According to Ned Davis Research, based on the S&P 500 from January 1972 to April 2009, the annual gain for stocks of dividend growers and dividend initiators was 8.7%. Stocks which did not pay dividends returned less than 1%. Stocks that reduced their dividends at some point, earned 0.5% per year.

To build off of this information, one would start with the requirement that all stock holdings must pay a dividend. The companies should have a dividend yield that equals or exceeds its industry group. They must be growing earnings on a forward looking basis. They must be large cap companies. They must have a history of maintaining or growing dividends. They must have a payout ratio that is reasonable as compared to their industry peers, and not exceed 80% of earnings.

A US model that has followed a similar approach, has managed to average an 11.1% annual return over the past 18 years, while having meaningfully lower volatility (a Beta of 0.7 or 30% less volatile than the overall index) than the S&P 500.

Covered Call Writing – This strategy can be complicated, but in a nutshell it lowers risk and increases income. Exactly what the income investor likes. The downside is that it will lower returns in very strong markets, so if the TSX returns 20% in a year, your portfolio might return 15%. The net result of using covered calls is that you boost the income of the portfolio, you generally outperform in down markets, you generally outperform in flat to slightly improving markets, and underperform in strong markets.

It can be achieved using some new ETFs from companies such as BMO and Horizons, or you can find some investment counsellors and brokers that have a particular expertise in this area.

One of the big positives of this strategy is that the income generated is considered capital gains for tax purposes. Not only is this a lower taxed type of income, but for those with a build up of capital losses over the years, this is one of the only ways to ensure a capital gain – effectively getting income with no tax (until you use up your losses).

Given the objectives of the investor (protect capital, boost income, more stability), this covered call option strategy can be very effective.

With these five components, you are able to have an entire investment portfolio without going out too far on the risk front with any security, but generating an income yield easily exceeding 4%. The reason is that the yield on bonds, preferred shares and common stock dividends should be close to 4% on its own. When you add on the income from covered call options, it will easily move you close to the 5% mark.

The key benefits for income investors to this approach are:income yield somewhere between 4% and 5.5% without holding high risk investments; lower volatility; better tax efficiency; total flexibility on cash withdrawals to meet personal needs.

This portfolio is almost certain to outperform the stock market in a down year but just as certainly it will underperform in a strong stock market. However, if many pundits are correct, we may not be seeing many 15%+ years in the market in the near future.

Why you need a Personal Financial Plan

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Over 25+ years as an executive in the business world, I have witnessed the value of a good financial plan to a company’s success. Corporations with excellent financial organizations reach their financial goals, or understand the key reasons they were missed. They have metrics for measuring progress and address gaps as they occur. They predict cash overages/shortages and have plans for how to deal with them. And most importantly, the organization’s missions/values and strategies are embedded in their financial plans.

In the same way, a financial plan is a critical tool for you to achieve your financial goals; when done well it will reflect your personal goals and values. Do you want to leave funds for your children, do you want to support a local charity or association you participate in, do you want to travel regularly, do you want to live financially independent in the near future, do you want to have a high “sleep at night” factor in your investments? All of these goals should be embedded in your financial plan.

A basic financial plan can help you identify “your number” (how much you need to retire) to guide you in your retirement investing. A good financial plan will do more than that: It will time your cash-flows in order to minimize your taxes and maximize your government benefits. It will provide a range of sensitivities on age, investment performance, and inflation so you can make the decisions today to prepare yourself for a variety of possible scenarios for your future. It will provide investment allocations that will maximize your capital preservation while minimizing your risk.

At critical stages in your life you should do a financial plan – such as when approaching retirement, a change in your family situation, or if you are looking for a 2nd opinion on your investment portfolio. There are many sources of a good financial planner, whether through the internet, the FPSC website or through your own network. Search for someone you feel comfortable with, have a sense of trust and respect to prepare a financial plan that reflects your goals, your values and your risk profile.

Gail Cosman
Senior Wealth Advisor
TriDelta Financial

How to Take Money out of Your Small Business Tax Efficiently

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This is part one in a multi-part series explaining some of the lesser know strategies used to effectively get money out of your corporation most tax efficiently.

Many small business owners work a lifetime to build up retained earnings in their corporations, only to have CRA punish them with double taxation when they decide to take that capital out of their business.  If you have planned well, you’ve maximized your RRSPs or other savings vehicles and have paid down personal debt.

Through good planning advice, you can distribute money out of your corporation in various tax-preferred ways.

  • Declare dividends to a lower income shareholder (Spouse or Children over 18). 
    • You can issue shares to children over 18 years of age, as well as your spouse, and declare dividends to those share classes.  In many cases, these dividends can be received with almost no tax implications.  This can be very helpful in funding post-secondary education, or other expenses relating to your children
  • Utilize the Capital Dividend Account (CDA)
    • 50% of any taxable capital gains generated inside the corporation will credit the CDA
    • Death benefits of a life insurance policy less the Adjusted Cost Basis will also credit the CDA
    • Capital Dividends can be distributed to shareholders tax free.
  • Refundable Dividend Tax on Hand (RDTOH)
    • Between 25-33% of Investment income earned inside a corporation (excluding capital gains), are credited to the RDTOH.
    • The company recovers 1/3 of every taxable dividend dollar it pays out against this account.

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Utilizing the CDA and RDTOH still requires you to take on investment risk associated with generating the income necessary to utilize them.  If you still find yourself with the problem of having too much capital locked inside your corporation, be it your operating business or your Holding Company, there are some other ways to deal with it that will cut CRA out – and many are risk free.  There are a few examples that involve permanent life insurance, which will be addressed in Part 2 of the blog.

Many of these strategies require proper advice and guidance to ensure they are done properly.   Be sure to sit down with an estate and tax planning specialist to review your business’s specific situation and to learn which strategies may be best. To learn and understand more please contact us here at TriDelta Financial.

This article was written by our VP- Estate Planning, Asher Tward.

 

 

 

 

 

 

 

 

Maxed out RRSP & TFSA? An Alternative Tax-Sheltered Retirement Strategy

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There is an alternative tax-sheltered retirement strategy that is a substitute for RRSPs or tax-free savings account. This strategy allows you to invest a set amount every year (that you can comfortably afford) and guarantees that you generally earn a return of around 8% after tax, annually. In your late working years or early retirement, you receive a tax free payout. The investment does not move up and down with the stock or real estate market.

Intrigued? Here is how it works:

•You have maxed out your RRSPs. This could be because your income is high and you have good savings, or you have a sizable pension contribution, or as a self-employed individual who receives dividends you have very little RRSP room to use, and your TFSA is maxed out.

•You have a parent or in-law, aunt or uncle, who is in reasonably good health for his or her age, and is somewhere between 60 and 80. Reasonably good health means no recent or current cancer, heart attacks or strokes or other major diseases.

•You take out a permanent insurance contract on this individual. With permanent insurance, if it is held until death, it is guaranteed to provide a payout. For example, if someone puts in $12,000 a year for 15 years, that totals $180,000. The insurance policy might pay out $360,000 in 15 years. This is different from a “term 10” or “term 20” insurance policy that covers only a fixed time period, and usually has a return of negative 100 per cent. Permanent insurance allows you to know the payout on the investment. The only unknown is when the payout will occur.

•To implement the strategy, you would search the market for the best permanent insurance solution given the age and health status of the individual. That will require an insurance broker who has access to the full market, focuses on estate planning and understands the strategy.

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To better understand this life insurance strategy, here is an example:

We have an imaginary investor, Joe, and he is 41. His yearly income is $200,000, and he has no more room in his RRSP or TFSA. He has $150,000 in non-registered investment assets (and these are being taxed).

Joe’s mother, Susan, is 70 and in decent health (except for a bad knee). Joe’s insurance broker has searched the market to find the best return for a permanent policy for a 70-year-old woman. Joe deposits $12,000 a year for 15 years and the policy is fully paid up – a unique feature of this particular product. This policy also has a return of premium. It essentially adds one dollar of payout for every dollar Joe puts in.

After one year, Joe has put in $12,000. If Susan passed away, the insurance payout would be $193,000, for a return of 1,508 per cent. Every year Joe puts in $12,000, the payout goes up $12,000. In year five, Joe would have put in $60,000 and the insurance payout would be worth $241,000. In 15 years, Joe has put in $180,000. In this case, the policy is now fully paid, and Joe doesn’t need to pay another dollar. The payout figure does not continue growing past this point.

As it turns out, Susan passes away shortly after, at age 85. Joe is now 56 years old. The insurance policy pays out $361,000 to the beneficiaries. In this case, Joe is the sole beneficiary.

If Joe had put the same $12,000 a year for 15 years into a non-registered GIC, to have the same after-tax return as this strategy (assuming Joe pays a 46 per cent marginal tax rate), he would have to find a GIC paying 15.35 per cent.

Not only did this strategy provide Joe with extra tax shelter, but it guaranteed he would at least double his money, tax free, whether Susan lived to age 71 or age 95.

Read Part II to learn about the benefits of using life insurance as a retirement savings tool.

Why Should I Use a Tax Professional in Canada?

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Have you ever wondered about the benefits of using a professional tax preparer in Canada?

We asked the same question to a highly rated local company and received the following response:
Tax laws can be complicated and change frequently. Your unique situation also changes year to year. Using a professional tax consultant ensures you pay as little tax as possible.  They can dig into your financial situation and are trained to find all the applicable credits available and ensure fast accurate filing.

Over the years, Canada Revenue Agency (CRA) has changed the way they process, monitor and verify the accuracy of the individual returns. They continue to improve their ability to automatically process and validate tax returns as they are filed. They have also improved their ability to verify if a taxpayer has included all pertinent financial transactions in their annual tax return. It is more important than ever that you include all income, deductions, and credits applicable to your unique situation. A tax professional will work with you to ensure this happens.

A tax professional will also review:

  • Your revolving life situation, which results in new or different credits/deductions. Marital status, dependants, even taking care of your parents, can provide opportunities to minimize your tax liability.
  • Programs such as the Home Renovation Tax Credit and Pension Income Splitting must be calculated and reported correctly.
  • Which spouse should claim the Child and Children’s Fitness Tax Credit
  • Your ability to split Capital Gains/Losses and other Investment Income with your spouse.
  • Fees paid to your tax professional are also considered tax deductible.
  • They might show how  you can donate “in kind” to charity. You should consider donating appreciated securities directly to your charity of choice and eliminating all tax on any accrued capital gains.
  • You will be encouraged avoid getting a tax refund. If you get a large tax refund each year, consider applying for a reduction of tax at source using CRA Form T1213.

Benefits of Using a Tax Professional

Establishing a relationship with a financial planner and tax professional means that you will have a team looking out for money saving opportunities that apply to you. You will benefit from their specialized skills and have the ability to discuss life changes to determine how your financial and tax situation may be affected.

Canada: Proper Tax Planning is Not Yearly Tax Minimization

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Contrary to conventional wisdom (and some advice from accountants and tax software), getting your year-end taxes to be as low as possible is not necessarily good tax planning. It looks good on paper, but to truly be tax efficient, you need to think beyond this year.

Here are three examples of short-term tax planning strategies that may cost you thousands in lifetime taxes:

1) Refusing to withdraw money from your RRSP until you are forced to at 71.

In many cases, people don’t take money out of their RRSP in their 60s because it will increase their tax bill in that year. All this does is defer large taxes for the future. If your income now is lower than it will be after you are 71, start withdrawing from your RRSP. You will be taxed at a lower rate. In addition, you can prevent your income from going beyond the Old Age Security threshold. Finally, you will prevent your estate from taking a massive tax hit as your remaining RRIF balance is taxed as “income earned in one year” upon death.

2) Always putting off taxable capital gains as long as possible.

Again, if you are in a low-income situation in a particular year, it may make sense to take the capital gain now, and not put it off.

As an example, if you have a $10,000 gain on a stock and sell it, your capital gain tax could be $2,300 (23% in Ontario) if the sale takes place in a year when you are in the top marginal tax bracket. If, instead, you are in a much lower tax bracket in a particular year, the tax bill on the same stock sale may be $1,200 (12% in Ontario). If your income fluctuates, save on capital gain taxes this way.

Proper Tax Planning is Not Yearly Tax Minimization

3) Always getting the tax refund from your RRSP contribution.

It doesn’t always make sense to claim an RRSP contribution in a low-income year – even though it will always lower your current tax bill. Let’s say you make $35,000 this year, but next year you expect to make $90,000. You can still make an RRSP contribution to get the tax sheltering this year, but it is better to carry forward the deduction until the next year. In this example, you could get an extra 23 per cent refund by waiting one year to claim the deduction. That is a pretty good return in any year.

In all of these cases, it is important to understand your long-term financial picture instead of trying to simply lower your yearly tax bill. To get a sense of your long-term tax bill, try out the free Tridelta Retirement Tool. It calculates the amount of taxes you will have paid over your lifetime based on a few simple questions.

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