Keys to tax-efficient investment portfolio

With tax season upon us, it’s important to revisit how tax efficient your investment portfolio is.  Fee-based accounts may provide tax benefits for investors who have non-registered investments or simply want to tax shelter more within their registered accounts.

On Schedule 4 of your income tax return you are able to enter items such as interest expense, safety deposit box charges, and investment counsel fees (relating to non-registered accounts).  The total of these are then carried forward to Line 221 (Carrying Charges and Interest Expense) and can be deducted on your income tax return.

Designation titles for financial professionals are changing.  In years past, stock broker and investment advisor were accurate descriptions as the services provided primarily related to picking investments.  Today, many financial professionals are realizing that clients are requiring a much more comprehensive type of service, and titles today – such as wealth advisors – are beginning to reflect this.  It is the complete package of services today that would be referred to as investment counsel fees.

We recommend everyone who has non-registered accounts to read Canada Revenue Agency’s (CRA) interpretation bulletin (IT-238R2) on this topic.  This bulletin is available online at www.cra-arc.gc.ca or by requesting a copy to be sent by mail 1-800-959-2221. After you have read this bulletin, and looked at your current accounts, you should check with your accountant to see if you are deducting100 per cent of the cost of investing in your non-registered account.

The best way to understand the benefits of a fee-based account is to compare it to a traditional transactional account.  We will use an investor named John who is in the process of setting up a non-registered account after he received an inheritance.

John already has an RRSP account where he holds a laddered fixed income portfolio.  Based on our review a transactional account is the most suitable type of account for John’s RRSP.  Only a couple of trades a year are required to reinvest maturing bonds within his RRSP.

John is interested in buying some individual equities and is unfamiliar with the costs associated with the initial purchases.  We explained to John that some investors open transactional accounts, and others open fee-based accounts.  The term “commission” is often associated with transactional accounts.

For every trade within a transactional account, an advisor would charge a commission.   The amount some advisors charge for smaller transactions may be around two per cent.  As the dollar amount of the transaction increases, the percentage may decline.  Most fee-based accounts are not charged a commission for trading activity.  The fee is based on the market value of the investments within the account.  Some advisors charge a lower fee as the market value increases.  John has approximately $500,000 and we will assume his fee is one per cent for the illustration below.

Assumptions:

  • John has $7,650 and would like to buy Royal Bank
  • John buys Royal Bank at $42.86 on January 1
  • John sells Royal Bank at $50.00 on December 20
  • John is in the 30 per cent marginal tax bracket.

Transactional Account

Factoring in commission, John is able to purchase 175 shares of Royal Bank.  The buy confirmation slip for Royal Bank would have a total purchase price of $7,500 plus a commission of $150 (two per cent x $7,500).   The total adjusted cost base is $7,650.  When John sells the shares on December 20 the proceeds are $8,750 less a commission of $175 equaling $8,575.   For tax purposes John would report a capital gain of $925 ($8,575 – $7,650).  The taxable portion is one half of this, or $463.  Assuming 30 per cent marginal tax rate, CRA’s share is $139.  Most importantly, what did John make?  John made $786 after taxes and commissions (plus dividends on Royal Bank).

Fee-Based Account

Commissions are not a factor when making purchases in a fee-based account.  We do have to factor in the fee that is paid to the advisor based on the market value of the investment.

One difference you will see right away is that John is able to invest the entire $7,650 into Royal Bank as there is no commissions.  John is able to buy 178 shares (rather than 175 shares in the transactional account) and still has $21 left over.

The buy confirmation slip for Royal Bank would have a total purchase price of $7,629 and this would also equal the adjusted cost base.

When John sells the shares on December 20 the proceeds would equal $8,900.  For tax purposes John would report a capital gain of $1,271 ($8,900-$7,629).  The taxable portion is one half of this, or $636.

Assuming 30 per cent marginal rate, the estimated tax on this amount is $191.   We estimate John would pay $83 in fees to the advisor relating to the market value of the amount invested.

This fee can be claimed on Schedule 4 and will result in a deduction and tax savings of $25 ($83 x 30 per cent).   CRA’s total share of this transaction is estimated at $166 ($191 – $25).

What did John make with the fee-based account?  John still had the residual cash of $21 not invested at the beginning plus the proceeds from the investment.  If we estimate the net amount owed to CRA ($166) and the fees paid to the advisor ($83), John made $1,022 after taxes (plus dividends on Royal Bank).

Let’s compare the above two options.  John made $786 in the transactional account versus $1,022 in the fee-based account.  John was further ahead by $236 for this one transaction.  If we assumed John had 30 companies in his portfolio with the same situation, annually he would be further ahead by approximately $7,080 with the fee based account.

The above highlights the tax savings of a fee based account.  The main reason for the difference is that the transaction commissions are higher and they are built into the adjusted cost and proceeds.  This effectively means that only one half of the commissions you pay will ultimately be able to potentially be deductible.

Other factors that influence John’s decision are:  type of investment account, level of trading activity, and the types of investments purchased are all key components.  If a person has net capital losses of other years then you should look even harder at the benefits of fee-based accounts.

If every purchase and sell you make in your account excludes commission charges then it increases your chance of having capital gains and being able to utilize both the tax deduction and loss carry forward room.  Another component to factor in is that fees are deducted in the year paid and you do not have to sell your investments.