At the end of 2023, and beginning of 2024, it was possible to purchase Guaranteed Investment Certificates (GIC) between the five to six per cent range. With an inverted yield curve at the time, the one-year GIC offered the best yield. The yield would drop for a two-year GIC, and more significant drops for anything three years and beyond.
As a result, many investors kept the duration of their GIC purchases to one or two years. Now that the Bank of Canada has made several interest rate cuts beginning in the middle of 2024, the GICs that were purchased when rates were higher are all coming up to maturity when the rates on GIC investments are now much lower.
Reinvestment risk
For fixed-income investors, fluctuations in interest rates have a material impact. Using a GIC investor who had $1 million invested at 5.8 per cent previously, they would have earned $58,000 in interest income for the year. If rates are now 4.1 per cent, the same investor will now only earn $41,000 for the next year — a drop of $17,000. This fluctuation in income is often referred to as reinvestment risk and impacts fixed-income investors far more than equity investors.
Dividend growth rate
Let’s now look at equity investing using common shares. If you have $1 million invested last year in dividend paying equities, with an average yield of 4.5 per cent, you would have made $45,000 in dividend income. Most of the companies we invest in will increase their dividends annually.
It is a relatively easy exercise for Portfolio Managers to look up the annual dividend growth rate for selected securities. Focusing on those companies that increase their dividend payout to shareholders, over a number of years, will result in you having an income stream that increases every year and is more stable.
The best part of this strategy is that dividend income is the best form of taxable income for most individuals that have taxable investment accounts. Taxable investments accounts can be individual non-registered accounts, corporate accounts and trust accounts. A non-registered account can be referred to as a taxable account, cash account, margin account, and joint with right of survivorship (for couples) — lots of different names, which can cause confusion.
Generating a stable tax-efficient income
Understanding the taxation of investment income is a key concept that we explain to all new clients that have non-registered investment account. Even our existing clients need to be reminded of taxation features from time to time. Looking at your actual rate of return, net of tax, is far more relevant than looking at posted gross rates of return before tax.
The most tax-efficient investments are equities. When we begin talking about equities, we have, from time to time, come across individuals that have avoided equities.
Reasons for avoiding equities
I’ve heard people saying that they don’t like equities. When I hear this, it is worth spending time to have a meaningful discussion about why they feel that way.
Ten reasons we have heard:
1) They speculated in high-risk equities in the past and lost money
2) Invested at the wrong time in the market cycle (at a high point) and ended up selling when the markets pulled back (at a low point)
3) Concentrated in one speculative position that did not have a positive outcome
4) Listened to a neighbour’s ‘hot’ stock tip that came from an uninformed position
5) Read the next ‘hot’ trend on a social media platform (don’t believe everything you read)
6) Fear resulted in selling when the investment declined
7) Not feeling comfortable with the unknown (i.e. political and world events)
8) Dealing with volatility is tough to stomach and losing sleep at night
9) Retirement approaching and feeling the need to invest the portfolio conservatively to preserve and protect
10) They don’t have the time to do the proper research
Ten reasons to hold equities
1) Ability to have superior long-term returns
2) Tax-efficient dividend income
3) Tax-efficient capital gains
4) The ability to have deferral of capital gains if the position is not sold
5) Protect your funds against inflation and purchasing power
6) Transparency of holdings – knowing exactly what you are holding
7) Ensures your investments will last throughout retirement
8) Enables diversification
9) Ease of liquidity (some fixed income is locked in, real estate and other assets can not be sold quickly)
10) Having an income stream that increases over time regardless of the direction of interest rates
Types of investment income
There are four types of investment income: interest income, Canadian dividend income, foreign dividend income, and capital gains. We will assume that an investor has $1,000,000 to invest and that each category of investment income earns 5.0 per cent annually.
We have done a two-part analysis to illustrate this. Part I – investors have no other income other than the investment income. Part II – investors have other sources of income that brings the marginal tax bracket up to the top tax bracket. We will illustrate how much of the investment income goes to the CRA at both ends of the marginal tax brackets.
Part I – Investment income is the only source of income
Interest income
There are various types of fixed income that pay interest income, such as guaranteed investment certificates, corporate bonds, debentures, provincial bonds, and federal bonds.
Calculating the net return (assuming five per cent):
Amount invested $1 million
Gross rate of return $ 50,000
Tax payable to CRA $ 7,481
Net rate of return $ 42,519 ends up in your pocket
Canadian dividend income
There are many Canadian dividend paying stocks that have dividends at five per cent or above.
Calculating the net return (assuming five per cent):
Amount invested $1 million
Gross rate of return $ 50,000
Tax payable to CRA $ 0
Net rate of return $ 50,000 ends up in your pocket
Capital gains
There are many U.S. and Canadian stocks that do not pay a dividend or have very low dividends. We have assumed that we realized capital gains on appreciated stocks at five per cent, consistent with the above. One of the attractive components of capital gains is that you are only taxed on 50 per cent of the realized capital gain.
Calculating the net return (assuming five per cent):
Amount invested $1 million
Realized capital gains $ 50,000
Gross rate of return $ 50,000
Tax payable to CRA $ 1,904
Net rate of return $ 48,096 ends up in your pocket
Part II – Investment income added to other taxable income
In most cases, our clients have other forms of income, such as employment income or pension income. When you add the investment income on top of the other forms of income, then looking at tax-efficient options is even more important. Below we have run the same level of investment income, and how it is taxed with a client who has other sources of income that brings them up to the top marginal tax bracket before investment income.
Interest income
Calculating the net return (assuming five per cent):
Amount Invested $1 million
Gross rate of return $ 50,000
Tax payable to CRA $ 26,798
Net rate of return $ 23,202 ends up in your pocket
Canadian dividend income
Calculating the net return (assuming five per cent):
Amount invested $1 million
Gross rate of return $ 50,000
Tax payable to CRA $ 18,271
Net rate of return $ 31,729 ends up in your pocket
Capital gains
Calculating the net return (assuming five per cent):
Amount invested $1 million
Realized capital gains $ 50,000
Gross rate of return $ 50,000
Tax payable to CRA $ 13,375
Net rate of return $ 36,625 ends up in your pocket
Deferral should be factored
One of the cornerstones of tax planning for our clients in the top tax bracket is deferral. Paying a dollar of tax tomorrow is better than paying a dollar of tax today. This assumes that the level of taxation increases does not outweigh the deferral component.
We have designed portfolios for clients, who are already in the top marginal tax bracket, to generate growth in the portfolio with minimal interest and dividend income. When our clients stop working, their regular income will drop into a lower marginal tax bracket, enabling them to realize capital gains at that time. Even if income does not drop in the future, the concept of deferral is still beneficial.
The key component from the above analysis
Capital gains and deferral for higher income individuals is the best form of income. Individuals who have lower levels of income will find dividend income to be very tax efficient. Whether your income is at the lower end or higher end of the marginal tax brackets, interest income will always result in the highest level of tax and has zero deferral opportunity.
Time horizon
The above analysis shows the impact of taxation for one year. The power of compounding those tax savings over many years is huge. Time also puts past volatility into perspective, and over a number of years, returns are smoothed out.
Equity returns have always surpassed fixed income returns over any reasonable time period. The opportunity cost for not having good dividend-paying equities and focusing only on GIC investments is very high. Many of our working clients have 100 per cent in equities today. Our clients in retirement have a mixture of cash equivalents, fixed income (in some cases), and equities.
Reasons to work with a Portfolio Manager
There are many great reasons to work with a Portfolio Manager when it comes to the selection of investments and planning.
1) We have a fiduciary responsibility to do what is right for clients
2) Experience in dealing with market cycles and designing the appropriate asset mix
3) We can assist you in generating more tax-efficient income and reduce the overall tax you pay on that income
4) Will keep you on track when markets get volatile and avoid making emotional decisions
5) Integrate the investment component into your Total Wealth Plan
Equities help clients deal with longevity
Our Total Wealth Plans used to have a life expectancy assumption to age 90. Many of our clients are living well into their 90s and some have surpassed 100. Some clients have asked us to put life expectancy to age 95 or 100 within their Total Wealth Plans. Clients that retire in their 50s or early 60s will require their investments to generate a tax-efficient return sufficient to deal with the longevity of retirement.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email [email protected], or visit greenardgroup.com.
