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The Art of the Tax Efficient Portfolio

By Robb Lovell, MBA


Most people who want their money to work hard would probably jump at a 7% rate of return over a 5% return.  But there is much more to the overall rate of return that an investment will provide than just the raw numbers that you might see in advertisements or investment publications.  What is important to the individual investor is the after tax rate of return.  The after tax rate of return is determined by the type of investment income or growth that occurs as well as the individual investor’s own marginal tax rate.

The type of investment income is important since different types of investment income are taxed differently.  For example, most people wouldn’t see much difference between $100 of interest income and $100 of dividend income.  But someone with about a 50% marginal tax rate on this investment income would hold on to about 32% more money on an after tax basis if they opted for the dividend income instead of the interest income.

In addition, investment growth is generally taxed differently than investment income.  Most of the time, investment growth, which represents an appreciation in the value of the investment, (such as the increase in price of a stock after it has been purchased) is called a “capital gain”.  The tax rules in respect of capital gains can get complex.  For example, just because the value of an investment has increased at the end of the tax year doesn’t necessarily mean that the increase must be reported for tax purposes, though sometimes this is the case.  With certain types of investments, the capital gain is only reported when the investment is sold at a profit; with others, all gain for the year is reported annually.  In addition, the rules on capital gains are also accompanied by corresponding rules on capital losses.  However, despite the complexity of the tax rules, capital gains offer a significant tax break (a tax break which the federal government has boosted gradually over the past couple of decades).

For example, the same investor with that 50% marginal tax rate would want $100 in capital gains instead of $100 in interest income from a tax standpoint since the capital gains investor would hold on to about 50% more than the interest income investor.

Obviously, tax rates and the types of investments can have a substantial impact on just how hard money works within a portfolio after the tax department takes it’s bite.

Moreover, while we have just seen that making the right investment choices can mean a world of difference with one investment, having the proper “balance” between the various types of investments from a taxation standpoint can make an immense amount of difference for an entire overall portfolio.
The proper “balance” depends upon the individual investor’s own tax rate, the investment objectives of the portfolio, the acceptable level of risk that should be with the portfolio for the investor and other factors.

In addition, over time, different types of investments grow or earn income at different rates, changing the various important ratios within the portfolio and also consequently changing that “balance” of investment types. 

A portfolio with an optimal tax efficient blend of fixed interest and growth investments at the beginning of the year will not have that same proper blend at the end of the year if the fixed interest investments grow at a rate of 5% and the growth investments at the beginning of the year will not have that same proper blend at the end of the year if the fixed interest investments grow at a rate of 5% and the growth investments grow by about 15% over the year.  Risk exposure also consequently changes, too.

These factors, along with changes in the investor’s own tax picture and changing tax legislation make it important to periodically “fine tune” a portfolio to ensure it is “on track” for optimal after tax growth. 

This type of periodic tax “fine tuning” can make a huge difference in the overall long term growth of the portfolio over time (and make for a much better looking tax return each year along the way for the investor, too).

Given the market growth rates we have seen over the course of 2004, 2005 (a stellar, record year for the Canadian Markets) and 2006 along with a low interest rate environment over that same period of time, it is now a favourable time to “fine tune” a portfolio so that it operates much more tax efficiently over the long run.

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