The importance of proper tax planning

Proper tax planning is a critical part of the investment management process.

What’s the point of spending countless hours on portfolio management to earn an extra 1 per cent per year in returns when you don’t bother to take a bit of time to reduce your tax bill by as much as 50 per cent?

Although tax planning is very important, a recent survey of Canadian investors found that almost half of their investment advisors had never discussed the impact of taxes at all. Of those advisors that had talked about tax, a third had taken no action to help with any tax planning measures.

How much can you really save? Let’s look at a client with $300,000 non-registered portfolio that’s invested in 50 per cent fixed income and 50 per cent equities. We’ll assume a 30 per cent marginal tax rate and an annual return of 8 per cent per year on the equities and 6 per cent per year on the fixed income.

With no tax planning, their growth at the end of the year would be taxed as follows:

Equities: $150,000 x 8 per cent, which equals $12,000 of capital gains, half of which is taxable, which equals $1,800 of taxes due.

Fixed Income: $150,000 x 6 per cent, which equals $9,000 of fully taxable gains. $2,700 of taxes due

Total tax bill for the year is $4,500 on the $21,000 of growth

Now let’s consider moving this same portfolio into a ‘corporate class structure.’ The investment managers will use carry forward capital losses and total structure expenses to offset much of the fixed income gains. Ideally, they would be able to offset most or all of the $9,000 of fixed income gains but let’s assume that they write off $5,000 of it:

Equities: $150,000 x 8 per cent, which equals $12,000 of capital gains, half of which is taxable. $1,800 of taxes due.

Fixed Income: $150,000 x 6 per cent, which equals $9,000 of gains but only $4,000 is taxable. $1,200 of taxes due.

Total tax bill is $3,000 for the year, a savings of $1,500.

But that’s not all. The taxes in this corporate class structure can also be deferred until the investor decides to withdraw some money. So how will that affect growth in year two? Let’s assume 1/3 of the equities are sold so that portion and all of the fixed income growth is taxable the year that it’s earned:

1. In the first scenario, the investor earns $21,000 of growth and pays $2,700 in taxes of the fixed income plus $600 in taxes on the equities. After tax, they now have $317,700 in their account. If they earn the same 7 per cent return in Year 2, they earn $22,239 of growth that year.

2. In scenario two, the investor earns the same $21,000 of growth and keeps everything inside the corporate class structure so pays no tax. The $321,000 they hold in year two earns $22,470 of growth.

In addition to having an extra $3,300 in their account, that extra $231 of growth in Year 2 is the really important part to look at. The power of compounding will allow the investor in the corporate class structure to earn significantly more money over time by having a larger amount left in the account to earn additional interest and growth each year.

It should be noted that the corporate class investor will still have some tax to pay when they eventually make a withdrawal, but they will still be left with a much larger amount net of taxes in the end.

Corporate class investment structures are just one of many tax management strategies that can be utilized to significantly improve your net investment returns. How you withdraw your retirement income is equally important so we will take a look at that further in next week’s column.