Reflect on investments during tax time

As a Chartered Accountant I’ve always felt that it is a good thing if a person owes taxes – it means that you had income. Investment income is generated from taxable capital gains, dividends, and interest income. When I worked directly in public practice as a Chartered Accountant we had the ability to see the investment returns of all tax clients. One thing for sure is that the returns would vary considerably based on how savings were invested and with who they were invested with.

From time to time, we would see an individual who had significant savings but was not generating sufficient income from those savings. To illustrate we use Betty Brown who received a $500,000 life insurance payment when her husband passed away two years ago. In our first meeting we reviewed Betty’s prior year tax return and current investments. We noticed a T5 (income tax slip for investment income) in the amount of $4,750 for interest income and some high cost mutual funds that were under performing. This translated to a return of less than one per cent before tax. The T5 that she did receive was fully taxable interest income from her GICs. In talking to Betty we discussed that our “income” goal for clients is four percent. In her case, that would be $20,000 versus the $4,750 she is currently receiving. We also notice that Betty was generating some rental income from an investment property. We scheduled a second meeting to show her our plan.

At the start of our second meeting we explained to Betty that not all income is created equally. Interest income is the worst type of investment income as it is fully taxable in the year it is earned. We explained how some equity investments generate tax efficient dividend income that qualifies for the dividend tax credit. We also outlined how she could take advantage of the deferral rule on equities. The deferral rule essentially means that Betty would not be taxed on any gains until she decides to sell the investments. Betty understood this quickly as we compared this to her rental income. Years ago she had bought an additional investment property to generate rental income. Annually she has to declare the rental income. The value of the property has increased over the years but she has not had to report this. When she sells the property she will have to pay tax on approximately one half of the profits from the property value increase. This is an example of both deferral and tax efficient taxable capital gains on the eventual sale. The rental income is not tax efficient – it is like interest income.

We also talked about how equities pay dividend income which is tax efficient. Dividend income is significantly better than both interest income and rental income. Betty was excited about both the increased income and the tax efficient approach of buying direct common and preferred shares. Betty mentioned that she was still nervous about investing in the stock market. I explained to Betty that she had approximately $250,000 already in the stock market through her higher cost and under performing mutual funds. Betty was also unaware that she was paying $6,750 which was embedded in her higher cost mutual funds ($6,750 was calculated by multiplying the $250,000 in mutual funds by the average management expense ratio of 2.7 per cent).

In the discussion with Betty we mapped out a plan to largely replace the GICs with ten preferred shares and to replace the mutual funds with thirty large dividend paying common shares. We recommended opening up a fee-based managed account that would enable us to set up the accounts with no transaction and commission costs. Betty’s cost of investing would drop immediately and she could also begin deducting the fees she pays as investment council fees on her tax return. The plan that we mapped out would lower Betty’s fees, convert the cost of investing so it is fully tax deductible, increase her income, improve the transparency, and ensure she has maximum flexibility and liquidity.

We outlined the specific investments Betty would receive and how the tax efficient income is generated. Betty really liked the expected income report and how we could automate transferring all of the dividend income directly from her investment account to her bank account on a monthly basis. Betty even thought that this would allow her to stop working part time.

Our biggest concern with new clients investing in direct equities for the first time is to ensure they understand that not every stock will go up. In outlining the above with Betty we explained how she will see more volatility in the 30 common shares versus the mutual fund approach. It is generally a success if 25 stocks go up in value and only five go down. The main focus should always be on the total account rising in value from net growth in the share prices plus generating approximately four per cent from income. The growth will be variable, and possibly negative in some years. Over a reasonable time, Betty should experience more positive years then negative while experiencing significantly higher after tax investment income.

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.