Tackling tax-efficient investing

Reader alert: This is part 1 of a five-part series. • Part 1: Tackling tax-efficient investing • Part 2: Capital gains mean tax-efficient investing • Part 3: Tax-efficient investing and dividends • Part 4: Magic of tax-efficient bond investing • Part 5: Tax-efficient investor behaviour

While tax-advantaged vehicles such as RRSPs and tax-free savings accounts are a sure bet for most investors, they are limited by the investor’s contribution room. Once that has been exhausted, investing in taxable accounts is the next step. However, at that point, the tax impact of making such a move must be investigated.

That’s because the impact of taxes on investment returns can be huge. While few statistics are available in Canada, U.S. studies show that in the ten-year period from 1999 to 2008, taxes reduced the annual return of equity mutual funds by 1.13 percentage points on average. Bond funds fared even worse because taxes lopped an average of 2.13 percentage points off their annual return.

Why does this matter? Investors typically save for their retirement over long periods of time. Through compounding, a difference of one or two percentage points in the annual return may mean the difference between a comfortable retirement and a frugal one. Tax-efficient investing may lessen the tax bite.

The ins and outs of tax-efficient investing

Tax-efficient investing is not about minimizing taxes. If that were the objective, it could be achieved very simply by holding investments which generate no return at all. Rather, the aim is to maximize the after-tax return.

Bear in mind that tax efficiency is only part of the story. Advisors should recommend products on the basis of their investment merits and their suitability to the client. While tax considerations should form an integral part of the exercise, a recommendation should not be predicated on tax considerations to the exclusion of other relevant factors. The investment dog should wag the tax tail and not the other way round.

First things first: Investment returns can take different forms, depending on the nature of the investment. Cash generates interest income. Bonds generate interest income and, to some extent, capital gains. Stocks generate capital gains and dividends.

The most common forms of investment return are:

• Interest income;
• Dividends from Canadian companies;
• Dividends from foreign companies;
• Realized capital gains, net of realized capital losses;
• Unrealized capital gains, net of unrealized capital losses.

Interest and foreign dividend income are taxed as ordinary income. In other words, they are taxed in full at the investor’s marginal tax rate.

Canadian dividend income is subject to separate tax rules relating to gross-up and the dividend tax credit, designed to avoid double taxation of dividends.

Maximizing capital gains

Capital gains have two relevant characteristics. First, they are more favourably taxed than other types of return, since only 50% of capital gains need to be included in income for tax purposes. Making the most of the favourable treatment of capital gains is an important principle of tax-efficient investing.

Secondly, capital gains are taxed (and capital losses allowed as deductions) only when they are realized, such as when the related investment is disposed of. As long as the investor continues to hold the investment, tax on the gain is deferred. Since the investor is free to decide when to dispose of the investment, the timing of the payment of tax on capital gains is, to some extent, discretionary.

It is always preferable to pay tax later because the money can be invested during that interval, earning additional returns. The deferral of taxes on capital gains is another important principle of tax-efficient investing.

Implications for asset allocation

Investors’ tax bills depend on the mix of the different types of return that they earn on their portfolio. While the lightest burden is borne by investors who earn their return in the form of capital gains — especially if the related taxes are deferred for as long as possible — the biggest impact is on those who earn ordinary income such as interest.

The mix of returns depends to a large extent on the investor’s asset allocation, which is the process of dividing up the portfolio into asset classes such as stocks, bonds and cash. A portfolio with a large allocation to stocks will generate returns mostly in the form of capital gains and dividends. However, one with a large allocation to bonds or cash will generate returns mostly in the form of interest.

Best practice is to perform asset allocation with the use of a computer program known as an optimizer. This tool uses the expected return of each asset class and the related volatilities and correlations in order to generate efficient portfolios, i.e. portfolios with the least risk for a given expected return. The exercise is usually based on pretax numbers.

This approach is fine for tax-exempt investors such as pension funds. However, to the taxable investor, it is the after-tax return that matters and asset allocation should be performed using after-tax numbers. Because of the favourable tax treatment of capital gains, this will usually result in a larger allocation to stocks when compared with an asset allocation based on pretax numbers.

Losing money and still paying tax

When investors hold stocks directly, they realize a capital gain or loss when disposing of their investments. Only then do they pay tax on the capital gain or claim a capital loss. Things get more complicated when stocks are held indirectly through an investment fund. In such cases, investors may have to pay tax on capital gains even if they still hold the units of the fund.

When investment funds realize net capital gains on the disposal of portfolio investments, they routinely distribute the net gains to their investors, in whose hands the net gains are then taxed. This makes sense because, provided certain conditions are satisfied, investment funds may deduct for tax purposes the amount of distributions to their investors. Since most investors pay tax at a lower rate than the fund, the distribution of the net gains reduces the overall taxes payable.

The income of an investment fund retains its source identity when it is distributed to the investors. In this way, net capital gains distributed by a fund are taxed as such in the hands of investors.

This tax regime may produce disconcerting results for unwary fund investors. For example, in 2008 the markets dropped precipitously and most investors experienced negative returns. Despite their investment losses, many fund investors found themselves in the situation of having to pay tax.

When the markets dropped, most funds experienced net unrealized losses on their portfolio holdings. Those losses more than offset the net gains realized earlier in the year, with the result that the funds experienced negative returns for the full year.

What’s important to note in this situation is that net unrealized losses have no impact on a fund’s immediate tax situation. However, net realized gains are taxed in the same year.

In order to eliminate their tax liability, the funds distributed their net realized gains. As a result, their investors had to pay tax on capital gains in spite of a negative return on their fund investments.

What lesson can be learned? When investing through investment funds, investors should be wary of distributions since they trigger a tax liability. Investors have better results when the fund earns a return, not when the return is distributed.

If fund investors realize a capital gain when they dispose of their units, they must pay tax. This is in addition to taxes paid on capital gains distributed by the fund while they were an investor. However, no double taxation is involved.

Suitability and tax considerations

The investment should suit the investor. The investor needs to consider his or her overall situation, including investment objectives, risk tolerance, and the tax treatment of the investment.

By way of illustration, the equity portion of a portfolio may be invested in the stocks of companies that pay dividends or those that do not. In the latter case, the return takes the form of a capital gain, on which tax is deferred for as long as the stock is held.

An investment in a company that pays dividends suits investors who require current income, such as retirees. However, it makes less sense for investors with no need for current investment income, for example, because they are gainfully employed.

In such cases, the best use for the dividends is probably to reinvest them in additional shares of the company, thereby benefiting from dollar-cost averaging (buying a fixed dollar amount of a particular investment on a regular schedule, regardless of share price). However, the investors will be worse off by the amount of tax on the dividends.

It would be more tax-efficient for those investors to hold the stocks of companies that do not pay dividends and to earn their return in the form of unrealized capital gains — though this approach can be more risky. Companies that pay dividends tend to be large and well-established, whereas those that pay no dividends tend to be smaller companies in the growth phase.

However, the argument must not be pushed too far. In the wake of the major market correction of 2008, dividend-paying stocks have become increasingly popular with investors. Dividends are sometimes perceived as the proverbial bird in the hand — they are represented by hard cash.

On the other hand, unrealized capital gains are perceived as the bird in the bush — they are exposed to the market and may disappear if there is a downturn. The distinction is indeed valid if the investor intends to spend the dividends or to hold them in cash. However, if the dividends are reinvested, they become exposed to the market once again: the bird has flown back into the bush, leaving the investor with a tax bill in hand.

André Fok Kam is a consultant to the financial services industry and the author of the Tax-efficient Fund Investing Course offered by the IFSE Institute.