Successful portfolio building is most often achieved – and repeated – when chosen strategies rest upon time-tested foundations.
Such investment strategies in turn should incorporate or at least consider tax implications, given that almost half of investment returns can be lost to taxes. As the old adage goes, “It’s not how you make out; it’s what you take out.”
Here then are five tax principles that should underlie every client portfolio. Individually and in combination, these principles can help investors to achieve some absolute tax savings and otherwise defer the incidence of tax to a later date.
1. Cash preservation due to tax deferral
According to the concept of time value of money, a dollar received today is preferred to one to be received in future, all else being equal. Similarly, delaying an expense – such as a tax payment – keeps more cash available to an investor for the present and allows the potential for continuing gain in investment value until that payment comes due.
2. Less recognition through lower distributions
Income is generally a desirable thing, but for a mutual fund investor not seeking current income, it can be frustrating to receive unwanted distributions. Apart from having to redeploy those distributions – often right back into the same investment vehicle – there is current tax to be paid on that realized income and thus less money continuing to be invested.
3. Tax-preferred income with capital gains and dividends
It is not uncommon for novice investors to assume that investment income, like employment income, is fully taxable. Isn’t it as simple as totalling up your income and applying the appropriate tax rate to find out how much you owe? In truth, there is an important distinction as to the type of income before you apply that tax rate – such as one-half taxable capital gains and possibly lower effective rates on dividends.
4. Rebalance holdings without triggering taxation
It is important for an investment portfolio to be responsive to changing needs, whether prompted by market forces or investor circumstances. Within registered accounts like RRSPs and RRIFs, rebalancing may be undertaken without fear of triggering taxes. For non-registered accounts, however, dispositions generally trigger unrealized capital gains – except where a structure like a mutual fund corporation is used to defer that taxation.
5. Easing recognition via controlled drawdown
Retirees’ views on investment income taxation may be anchored in the registered investment world, specifically RRIFs. As registered accounts are held in pre-tax form, withdrawals are fully taxable. On the other hand, non-registered investments originate from after-tax funds and each withdrawal is normally a combination of non-taxable capital and one-half taxable capital gains – and it is even possible to have the early distribution of the non-taxable capital from some investment structures like mutual funds.