The fear arising from writing a large cheque to the CRA can often freeze investors who are trying to delay the inevitable. This “tax phobia” often leads to investors holding securities for longer than they should. A hyper focus on the tax bill can even cause investors to forget that gains are not a bad thing; in fact, they are the clearest sign that you made money! The worst thing that could happen is holding a security long enough for those gains to evaporate…
When deciding whether to make a change to your portfolio that would trigger a capital gain, there are a couple factors that investors should take into consideration:
- Expected relative performance of the securities (i.e. are these still good investments?)
- Cost of ownership (i.e. am I receiving good value for what I am paying for?)
- Annual tax drag (i.e. does my investment create an annual tax burden?)
Let’s illustrate an example of why this should not be overlooked for a non-registered investor with a 20-year time horizon:
|Maintain Typical Portfolio||Switch to Tax-Efficient Portfolio|
|Imbedded Gain (Cost of Triggering Gain)||$200,000 ($50,000)||N/A|
|Expected Total Return||6%||6%|
|Portfolio Allocation||100% U.S. Equities||100% U.S. Equities|
|Taxable Distribution||3% Foreign Dividends||None|
*Opening balance reflects $50,000 tax cost from the realization of $200,000 imbedded gain ($200,000 x 25%).
In review of the chart above, investors will notice a couple things:
- Annual Tax Drag - The Typical Portfolio grows inefficiently in a sawtooth pattern due to the annual tax burden (approximately 50%) arising from the receipt of foreign dividends.
- Breakeven Period - Despite the tax cost ($50,000) of changing the Typical Portfolio, it only takes a few years for the Tax-Efficient Portfolio to “break even” or catch up. The tax-efficiencies (reduced annual tax drag) of the Tax-Efficient Portfolio outweigh the lower opening balance ($950,000).
- Capital Gains - Both the Typical Portfolio and Tax-Efficient Portfolio are subject to capital gains upon disposition in year 20. Investors will notice that the gain on the Tax-Efficient Portfolio is larger due to the fact that it has been growing annually at 6% tax deferred until this time.
- Wealth Creation - The tax deferral (reduced annual tax drag) afforded by the Tax-Efficient Portfolio added $391,962 of wealth to the bottom line despite starting $50,000 behind initially.
All in all, investors should not feel “stuck in the sand” by capital gains in their portfolio. Through financial projections and thoughtful analysis, investors can weigh the merits of making a sound portfolio shift despite the prospect of triggering imbedded gains. The annual tax drag associated with a portfolio, as shown in the earlier chart, should not be overlooked – it is a key driver of the portfolio’s future growth potential.
For those that spend the time to investigate, there are tax-efficient investment solutions available to mitigate the effects of tax drag on your portfolio. Talk to your financial advisor to see if there are opportunities to keep more of your hard-earned wealth.
The illustrations and case studies presented are for informational and educational purposes only and should not be construed as legal, tax or investment advice. Information contained herein is believed to be accurate and reliable at the date of printing, however, Fiera Investments LP cannot guarantee that such information is complete or accurate or that it will remain current. The information is subject to change without notice and Fiera Investments LP cannot be held liable for the use of or reliance upon the information contained here.
Tax liabilities on investment income and capital gains earned by a mutual fund cannot be mitigated nor can they be fully managed in all circumstances. Therefore, a mutual fund may be required to make taxable distributions to investors in a Tax Class for which a distribution or type of distribution is not optimal or in accordance with their tax preference.
Fiera Investments LP does not provide tax, accounting, regulatory, or legal advice to its clients. All investors are advised to consult with their tax, accounting, or legal advisors regarding any potential investment.