Income tax is the largest expense in the budget of many Canadians, with shelter coming in a close second. For Ontario residents, the effective tax rate on a $100,000 working income is roughly 25%. For Quebec residents, it is 30%. (Please note, however, that these rates are not directly comparable since tax credits and deductions aren’t the same in both provinces.) By comparison, according to Statistics Canada, Canadians allocate 27% of their budget to shelter, on average. Thus, being concerned with portfolio income tax is completely natural.
Factors to Consider
If you own a non-registered portfolio (outside of an RRSP, RRIF, TFSA), the return that matters to you is the after-tax return. The construction of this type of portfolio must take into account the tax treatment of interest income, Canadian eligible dividends, foreign dividends and capital gains. And the portfolio must be considered within the overall context of your own personal situation (for instance tax bracket, career profile, participation in a pension plan, ownership of large registered assets, and financial and life objectives).
Tax-Advantaged Investment Vehicles
This is where “tax-advantaged” investment vehicles come into play. These vehicles usually belong to one of the two following types: structured products and life-insurance products. Structured products incorporate derivative products (forward contracts, options and swaps) to minimize the types of income that are most heavily taxed (interest and dividends) and to deliver returns in a form that is most advantageous from a tax perspective, most often deferred capital gains. Life insurance products, the second type of tax-advantaged vehicle, benefit from the fact that insurance claims are not taxable, by creating a product that is a hybrid between an insurance policy and an investment.
Minimizing Taxes Is Not the Only Success Factor
But, beware! While it is very important to choose the most tax-efficient investment vehicles available, there are other, equally important, factors to take into account when constructing your portfolio. Too often, tax-advantaged structured products and life-insurance products also carry serious drawbacks. First, their management and administration fees are often very high, which can more than offset the gains from their tax advantages. Another frequent problem is that once you buy the product, you are committed for the long run, without the possibility of exiting, except maybe at the cost of a large penalty. And lastly, tax-advantaged products commonly replicate the return of a narrow, under-diversified group of stocks and bonds.
Personally, any investment approach centered solely on tax savings makes me very uncomfortable. I believe overemphasizing tax minimization can result in serious errors in other important aspects of your investments. Here’s a brief list of the questions you should ask when considering an investment vehicle:
- Does the product improve my portfolio’s diversification per security, per sector or per geographical region?
- Does the product offer competitive fees? By our estimates, a balanced portfolio has an expected return of close to 5.00%. If the fees are too high, it’s like the worm eating the fish. In my assessment, fees in excess of 0.50% would disqualify any product.
- Does the product fit well within my current portfolio? What does it contribute that my portfolio doesn’t already have?
- Is the product tax-efficient? To me, this means the product allowing me to pay no more than my fair share of taxes. For example, products that pay very large foreign dividends (rather than capital gains) are highly inefficient because this type of income is taxed at the highest rate.
- Is the product simple, easy to understand? I’m very distrustful of complicated products.
- If I’m not satisfied, can I exit the product anytime I want and at a low cost?
- Is the product transparent? Will I be regularly informed of its returns? Is the information about this product regularly updated? Is it readily available? Is it concise and complete? Is it easy to understand?
I totally understand investors who are exasperated with the high cost of taxes, which are the largest expense for most middle-to-high income earners. Nevertheless, a strategy centered exclusively on minimizing taxes is likely to end up being counterproductive. An investor’s life is a long journey. For you to sail safely to destination, your portfolio must harmoniously combine the quest for returns, smart risk management, and fee and tax control—all within the context of your life goals.