Increasing your share of investment returns: Part One

What do proper asset allocation and mindful tax and fee management have in common? They are critical to increasing your share of investment returns you keep.

Market outcomes are beyond anyone’s control. While you can’t predict financial market returns, you can influence the level of investment returns you keep. I’m pleased to offer the first in a three-part series in “Views” on how to keep your share of investment returns. Tax efficient investing is a great place to start because it lies at the foundation of a successful long-term investment experience.

In Part Two, I’ll look at tax efficient income options, and in Part Three, I will offer ideas about keeping investment management fees low, another important part of a successful investment experience.

2006 was a good year. Did you keep your share?

As the April 30 tax deadline is now a memory, now is a good time to talk about tax management strategies to reduce their effect on your investment income. Your investments may have done well, but how much of those returns did you actually keep?

2006 was a very good year for the financial markets. Unfortunately, we know that many people did not receive their fair share of the markets’ return. (Please see “Views” - January 2007). To make matters worse, I suspect that taxes consumed a large share of those returns as well. Every investor needs to ask, “How much of my share did I keep and how much did I give to Ottawa?”

It appears that many people don’t really look at the implications of the amount of taxable investment income they receive. A good analogy is the right versus the left pocket. Investment returns enter the right pocket and then much of it leaves in the form of taxes from the left pocket. Somehow during that transition from the right to the left pocket, the overall return was diminished. I want to help you control that expensive vanishing act.

The amount of your investment return you keep after tax is hugely important in creating a successful long-term investment experience.

Remember that total investment return has two components: capital growth and income.
If an investment is going to return 10%, behavioural finance research suggests that most investors want a good portion of that 10% return in the form of income. “ A bird in hand, is better than two in the bush,” as the saying goes.

This desire for higher income ignores two very important realities: tax and the magic of compounding.

To explain the tax effect, let’s compare the after-tax returns of four investment options:

#1 $100,000 in GICs earning 5% / year - (100% of the return is in interest income)
#2 $100,000 in Equities earning 10% / year – (100% of the return is in dividends)
#3 $100,000 in Equities earning 10% / year – (100% of the return is in capital gains)
#4 $100,000 in Equities earning 10% / year – (100% of the returns are deferred)

Scenario #1 – Comparison over a One-Year Period

Original Cash flow Cash flow Ending Value
Amount Pre-tax After-tax* After-tax*
#1 – Interest $100,000 $5,000 $2680 $102,680
#2 – Dividends $100,000 $10,000 $7540 $107,540
#3 – Capital Gains $100,000 $10,000 $7680 $107,680
#4 – Deferred Gains $100,000 $0 $0 $110,000

*Note: Tax rates are based a 2007 individual Ontario resident in the highest marginal rate. Tax rates: interest income (46.4%); dividend income (24.6%); and capital gains (23.2%). These rates are subject to change. Deferred gains assume the investment is not sold at the end of the year.

Comparison over a 20 -Year Period

Original Ending Value Compounded Annual
Amount After-tax* Return (after-tax)*
#1 – Interest $100,000 $169,713 2.70%
#2 – Dividends $100,000 $427,957 7.54%
#3 – Capital Gains $100,000 $439,239 7.68%
#4 – Deferred Gains (after-tax)* $100,000 $539,872 8.80%
#4 – Deferred Gains (pre-tax) $100,000 $672,750 10.0%

*Note: Assumes the after-tax cash flow is re-invested each year and no changes in tax rates over the 20-year period. It also assumes that the Deferred Gain (after-tax) investment is sold in year 20 and all capital gains taxes are paid. Taxes owing are $132,878 ($672,750-$100,000 * 23.2%).

I should point out the huge advantage of #4. The main reason this option yields a much better result than if annual tax was paid on interest, dividends or capital gains is the power of compounding. As an investor, you receive compound growth on the portion of the return you don’t relinquish to the government in the form of tax payments. When you compound that advantage over 20 years, the results are significant.

If the government ever follows through on anticipated capital gains tax relief, such as lowering capital gains tax rates, the advantage of deferred capital growth would be further enhanced.

Years ago, research by Nobel Prize winners Merton Miller (Economics 1990) and Franco Modigliani (Economics 1985) taught us that money is money, whether it comes in the form of dividends or from capital growth. There is no reason to prefer one source above the other.

I would suggest in taxable accounts, interest, dividends and capital growth do matter. Investors seeking to maximize their long-term, after-tax rates of returns should focus on investments with the highest amount of deferred capital growth.

Remember, it is not how much you make, it is how much you keep after tax!