Month: September 2011

The Tax Efficient Divide

With so many unknowns, it can be challenging for clients to prepare for the future. But there is one very simple and effective strategy that they can use to help reduce their tax bill and that revolves around the power of tax deferral. Research shows that tax deferral can potentially increase returns on tax inefficient assets by as much as 1.0% without a subsequent increase in risk simply by allocating assets between taxable and tax deferred vehicles based on their tax treatment. This difference could also be called the Tax Efficient Divide.

A recent survey suggests that the collective financial literacy of Canadians is low when it comes to tax smart investing. In fact 76% of investors do not consider tax implications when they invest. There are two major reasons for this deficiency. First, not everyone realizes different classes of investments are taxed at different rates and unfortunately for the risk averse, safe interest bearing investments are the most punitively taxed. And second, even though there are numerous approved deferment vehicles such as RRSPs and TFSAs very few people understand them and even less take full advantage of them. For example during the 2011 RRSP season, fewer than 40% of Canadians made contributions. Being oblivious to taxes is not necessarily harmful but ignoring easy strategic opportunities can hurt the client’s bottom line.

Quite simply, tax efficient items such as capital gains on equities and domestic dividends generate long term gains and income while subject to relatively low tax rates. Tax inefficient assets such as interest income and foreign dividends generate ordinary income which can be taxed at rates as high as 50%. Obviously tax consequences should be considered equally with traditional risk and return considerations when investing. This is why a textbook asset location strategy would put all the tax efficient asset classes in non-registered accounts and all the tax inefficient asset classes in registered accounts.

Clients must recognize that tax minimization and deferral is crucial. Managing the complexities of long term planning and the responsibilities of providing prudent investment means having a handle on every part of the financial picture, including taxes. By placing assets in the appropriate taxable and tax deferred “buckets” while ensuring adequate diversification, the optimum tax treatment can be achieved.

In response to today’s volatile markets, data suggests that many clients are shunning buy and hold strategies and adopting a more tactical approach. Saving for retirement, like all important goals in life, requires an active approach. The basic building blocks of good investing will not change: establish a goal, create a plan, be disciplined and do not overreact. By taking an active approach clients may generate short term capital gains. If they can manage risk and preserve capital, the tax bill is secondary. Nonetheless minimizing taxes on tactical strategies can benefit clients and enhance their portfolio’s performance. That is when the Tax Efficient Divide comes into play.

Tax deferral options are limited, especially for high net worth clients once they maximize their registered contributions. When it comes to helping clients maximize returns in order to generate 30 or more years worth of retirement income, many clients need to seek out solutions to outperform the market with minimal risk. When clients use a tax deferred vehicle that allows assets to grow and only pay taxes when they need some money, it enhances performance potential in a meaningful way.

An asset location strategy only makes sense with clients who have both taxable and tax exempt assets. If clients have everything in a tax deferred account, the asset location question is moot. But once you start to have a relatively good mix between taxable and tax deferred vehicles, clients will start to see the real benefits of the Tax Efficient Divide.

Trends clearly indicate that there will be a greater demand for tax awareness when it comes to portfolio construction. Using tax deferral strategies to unlock the potential for greater performance can help clients complete their long term investment strategy and reach their goals sooner.

Some mutual fund investors use corporate class funds to minimize tax liability. Other investors incorporate fee and tax efficient managed accounts programs to mitigate the negative impact of taxes. Regardless of how it is done, in today’s environment where every single basis point of performance counts, tax minimization and deferral is important and the Tax Efficient Divide will become a must have approach to investing.