In a recent interview, MoneySense Editor Jon Chevreau asked Mercer actuary Malcolm Hamilton whether he still thinks that saving in taxable accounts is futile and Mr. Hamilton had this to say:

It’s always better to invest inside tax shelters than outside. Some Canadians have to invest outside tax shelters because they exhaust their tax shelters and they still want to save more. So they have to save outside. The problem is if you are earning, you know, let’s say, 3 or 4 percent interest and it’s 50 percent taxable, then it means after tax it’s 1-1/2 to 2 percent and, uh, in a 2 percent inflation world that means all you are doing in terms of purchasing power is marking time. So, when I say it’s futile you are not really going to make any money in real terms, after fees and taxes and inflation, you’ll be lucky to break even and in all likelihood for the forseeable future given how low interest rates are and how much that’s being done to get inflation a little higher, you may well gradually lose money. So, in that sense it is futile. It’s not a wealth generating activity. Now, if you have to invest outside tax shelters, it’s still maybe the best you can do. Like, maybe the best you can hope for is sort of a gradual, controlled loss of purchasing power. It’s sort of a depressing prospect but if that’s the only game in town, then that’s still the game you got to play. So, my advice to people is, by all means, if you can put your money in tax shelters do so. If you have to have some money outside tax shelters, again that’s probably where you want your equities. Your fixed income you can ill-afford to have outside tax shelters because they are taxed so heavily. So, to the extent that you got money inside, money outside try to get your heavily taxed stuff in the tax shelters and your more lightly taxed stuff like equities outside and just hope for the best.

As Mr. Hamilton is one of the sharpest guys around, it was surprising to hear him say that investing in taxable accounts is “not a wealth generating activity”. Mr. Hamilton is surely correct about investing in fixed income in taxable accounts and the superiority of tax-sheltered accounts such as RRSPs and TFSAs for holding investments. However, one would suspect that investing sensibly in taxable accounts is likely to produce satisfactory results. So, I constructed a model to compute the impact of distributions, inflation and taxes on investments made in taxable accounts. You can find it here. The model assumes an investment of $10,000 made over 25 years. The parameters are: expected total returns, returns in the form of distributions, inflation assumptions, turnover and tax rates on distributions and capital gains.

Let’s first test Mr. Hamilton’s contention that if one is invested in bonds or GICs in a taxable account, one is experiencing a gradual loss of capital in real terms. We’ll assume total returns of 2 percent, interest income of 2 percent, inflation of 2 percent and a tax rate on distributions of 45 percent. We find that investors are indeed losing capital at the rate of 0.90 percent every year. In 25 years, the initial capital of $10,000 has dwindled to $8,000 even though in nominal terms, the investment has grown to $13,000. Conclusion: Unless there is a very good reason such as a downpayment on a soon-to-be-purchased home or the college funds for a kid heading to University in the next couple of years, it is indeed a bad idea to invest long-term funds in fixed income in taxable accounts.

It is interesting to observe that even a 0 percent real return in fixed income in a low interest rate environment is better than a 2 percent real return in fixed income in a high inflation environment. Assume bond interest rate of 10 percent and inflation of 8 percent and we find that the real after-tax rate of return is negative 2.3 percent over a 25 year period. That is enough to turn $10,000 into $5,500 in real terms — a truly staggering loss of purchasing power. Conclusion: In high-inflation environment, you really should avoid investing in fixed income in taxable accounts.

But what about investing in equities? Is it worthwhile to do so in taxable accounts? Let’s make some conservative assumptions. Total return is 6 percent, 3 percent of which is supplied by dividends. Inflation is 2 percent and the portfolio is turned over 5 percent every year. The tax rate on dividends is 25 percent and on capital gains is 22 percent. Roughly, this model will capture the experience of an Ontario investor in the top tax bracket who has invested in a broad market Canadian index fund. In this scenario, we find that wealth does grow, albeit slowly in real terms. After 25 years, the initial investment has almost doubled in real terms and the real, after-tax rate of return is 2.8 percent. Conclusion: If all tax sheltered vehicles are exhausted, investing in equities while keeping costs and turnover low in taxable accounts will increase wealth, albeit at a modest pace in inflation-adjusted terms.

But what about investors who invest in typical mutual funds that charge a fee of 2.5 percent. The expected total returns drops to 4 percent compared to 6 percent for an indexed investor. Assuming distributions of 0.5 percent, one finds that the after-tax return drops to 1.3 percent, which will turn the initial investment of $10,000 into $13,700 over 25 years — that’s less than 40 percent of the growth experienced by the low-cost, low-turnover investor in the previous scenario. At least, the returns are not as awful as that of the fixed-income investor.

The model shows how powerful deferring taxes in investment accounts is. If an investor is comfortable with the Horizons S&P/TSX 60 Index ETF (TSX: HXT), which employs swaps to capture the TSX 60 total return and the total return is 6 percent and inflation is 2 percent, an investor ends up with an after-tax inflation adjusted rate of return of 3.2 percent over 25 years. That will turn an initial investment of $10,000 into $21,700 or roughly 20 percent more than an investor who incurs an annual tax hit on dividends and distributed capital gains. Conclusion: The total return swap structure employed by HXT, which avoids turnover and distributions, provides a strong advantage for taxable investors.

This article has 27 comments

  1. Would a loan to invest in HXT be tax deductible?

    • I’m no tax expert but I think the answer will be no. Borrowing to invest in HXT will not be tax deductible because Horizons explicitly says that they will not be distributing dividends or income. I’ll try and find out if I can get input from tax experts on this topic.

      http://www.horizonsetfs.com/Pdf/Prospectus/HJE_HXS_HXT_Prospectus.pdf

      • The interest deductibility is interesting. I would hope Horizons could offer an opinion or maybe any accountants reading this. On the one hand, according to Mott’s Tax Guide for Investment Advisors, p.332 “If the acquired property is capable of generating only capital gains and not income, then the interest deductibility test would not be met.” In the ordinary course of events, HXT should never cause anything but capital gains, upon sale only, for an investor … BUT …. as the prospectus says on p.26, there might be circumstances, like redemptions or wind-up of the swap, when HXT does distribute income. “there may be significant accrued gains in a Swap held by an ETF which, unless its term is extended, will be realized by the ETF as ordinary income in any year that the Swap matures or is otherwise settled. Such income will be distributed by the applicable ETF to its Unitholders in such year.” Would that be enough for CRA to accept interest deductibility? CRA never likes to have taxes deferred so maybe the interest deductibility impossibility is the trade-off.

      • Jean: I asked Horizons but they came back with “we’re not allowed to offer tax advice”.

      • CanadianInvestor:

        That sure sounds like enough to meet CRA’s standard.

        Shame Horizons is not willing to stick their neck out, even with the caveats of ‘this is not tax advice, consult your tax professional’.

  2. An investment doesn’t have to pay specific dividends or interest to be tax-deductible. It’s the expectation of profit that you need. Future capital gains would work as well.

    Regarding the FI outside registered accounts – If you invest $10,000 and it goes down to $8,000 in real terms – that may not be a great investment, but that doesn’t mean it isn’t worthwhile. If you need that $8,000 then what else are you going to do? Investing it in equities means it might not be there if you need it. And of course, just spending it guarantees it won’t be there.

  3. @Mike: Fair point on FI outside registered accounts.

    I disagree on the deductibility of interest on a loan used to purchase HXT because the test according to CRA is as follows:

    “borrowed money used for the purpose of earning income from a business or property.”

    Reference: IT-533, Interest deductibility and related issues.
    http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.pdf

    If an investor had borrowed money to invest in common shares that currently do not pay a dividend, the interest will be deductible because a company may decide to pay dividends in the future. Same applies for plain vanilla ETFs that pass through the dividend to the investor. However HXT is different. It has an explicit policy that it will not pay dividends. Therefore, I think CRA will conclude that interest on a loan to invest in HXT is not deductible.

  4. @Mike: On second thoughts, I agree that investing in fixed income in taxable accounts over short periods may not be such a terrible idea since stocks can take a huge hit.

    However, over long time periods fixed income isn’t without risks either. What if one invests in 2% bonds and inflation is at 4%? In that scenario losses can be much worse than the model. Stocks on the other hand, offer much letter odds over such long time periods of at least maintaining purchasing power. No guarantees with either option of course.

  5. Regarding FI – I definitely agree that for reasonably long time periods, there is no question that the money should be in equity.

    Regarding deductibility – my opinion is that investing in shares of a company (or ETF) that won’t pay direct dividends, but the underlying business will make income which will be ‘distributed’ in the form of capital gains makes that investment deductible.

    I suppose an argument against that would be that since capital gains are not taxable until it is realized, the gov’t might not want to give a tax break for an investment that might not result in any payable taxes for a long time.

    I will fully admit that the CRA might not agree with my opinion, but they would be wrong. :)

  6. Maybe it is early in the morning, but could you provide some numbers to substantiate:

    “It is interesting to observe that even a 0 percent real return in fixed income in a low interest rate environment is better than a 2 percent real return in fixed income in a high inflation environment. Assume bond interest rate of 10 percent and inflation of 2 percent and we find that the real after-tax rate of return is negative 2.3 percent.”

    This makes very little sense to me. Two parts to the statement. That investment in bonds with 0% real return leaves more after tax money than the 2% real return scenario. And, how does the second statement, 8% real return result in a negative after-tax return?

    • @Sampson: Sorry, there is a typo in there. It should read:

      “It is interesting to observe that even a 0 percent real return in fixed income in a low interest rate environment is better than a 2 percent real return in fixed income in a high inflation environment. Assume bond interest rate of 10 percent and inflation of 8 percent and we find that the real after-tax rate of return is negative 2.3 percent.”

      If we consider two scenarios (2% bond yield, 2% inflation and 10% bond yield, 8% inflation) with tax on interest at 50%, here’s how it works out:
      Scenario 1: 1% bond yield after tax. -1% bond yield after inflation.
      Scenario 2: 5% bond yield after tax. -3% bond yield after inflation.

  7. Oh good. I thought the government was starting to punish people who invested by claiming all their interest gains, and then charging them an extra 2.3% ;)

    • But effectively that’s what is happening when interest rates are 10% and inflation is running at 8%. $100 turns out into $97 in real terms a year later when invested in bonds in taxable accounts. That’s basically legal confiscation of capital.

  8. If you’re investing both inside an RRSP and in a taxable account, it’s imperative to allocate the least tax efficient income generating assets to the sheltered account. If you hold RRBs, the RSP is the place for them. Regular bonds next. Holding equity in your RRSP is volunteering to be taxed at a higher rate, since every dollar that comes out of the account is going to be taxed as regular income. You’re giving up the advantaged treatment for the dividends and expected capital gains. As long as you don’t churn your account, a taxable account is a great place for long term equity investing.

  9. My first though about the statement that most investors barely breaking even was that the simple answer is most people are really bad investors. The assumptions in the article, low interest rate over a long time period is bound to produce losses. It’s a no brainer.

  10. I know readers here consider Mutual Fund to be a dirty word but you have made no mention of the use of Corporate Class Mutual Funds in Non-Reg accounts. Many lower cost options exist in this format, some are 100% fixed income (tactical varieties with some Div stocks etc also exist). Any distributions are taxed as capital gains and distributions are rare.

  11. Someone who is uncomfortable with equity investing could read this article and figure once the TFSA and RRSP are topped up there is no point saving any more. The returns on fixed income instruments aren’t kind to risk adverse people.

  12. Perhaps a different perspective is one of maximizing income sheltered.

    Bonds face the most punitive tax rates, but with interest rates where they are, they are currently more about capital preservation than income generation. Equities on the other hand are held because of an expected risk premium of (say) 6%. So, if bonds pay 2%, equities return 8% on average. If an investor is in the highest tax bracket, they face a tax liability of ~1% of capital invested with fixed income in a taxable account (50% of 2%), and ~2% with capital gains/dividends (25% of 8%). So you actually avoid paying more tax by holding equities in a registered account rather than fixed income.

    This might be scalable for investors with lower effective tax rates. After all, just because an investor has run out of contribution room does not mean they have a very high income in retirement, facing the highest rate. Say an investors has taxable assets, no contribution room and an average income in retirement of $50k in Ontario. Fixed income is taxed at ~31%, capital gains/dividends at ~15%. Using the assumptions above, fixed income tax avoided is ~0.62% of capital invested per year, and for equities is ~1.2%. Add in the gross up from dividend income triggering clawbacks in OAS, and the effect can be even more pronounced.

    Bottom line: scarce tax shelter room should be used to maximize tax avoided per unit of capital, not as a % of income on that capital. At least in my opinion.

    • @Andrew F: While I agree with you that at current valuations a case can be made for holding bonds in taxable accounts, that may not always be true. If bonds yield 4%, the tax is 2%. And if stocks have an expected return of 8%, 3% of which is in the form of dividends, the annual tax is only 25% of 3% which is 0.75%. Yes, the capital gains will eventually be taxable but it can be triggered in a year when income is low and deferred for a very long time.

      Also, one has to be careful what to hold in a taxable account because dispositions can trigger taxes. It is not so much an issue with bonds or GICs because they can redeemed and switched into stocks with probably a small tax hit. That’s not true of stocks though. Stocks purchased in the past may trigger a lot of capital gains taxes if sold to rearrange the holdings to minimize tax.

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  14. I wonder if the other risk with fixed income (like bond funds) have another risk to consider. That is, with the specter of rising interest rates, the fund itself might take a capital loss due to owning assets that will have relatively low yield. While the same thing is clearly true for equities, I find most of the models miss the point that bond funds can, and likely will, go down in value in the coming years.
    Another reason to be cautious with bond funds outside a tax shelter

    • @Trying to save: Absolutely. If interest rates were to rise, bonds would suffer even more than modeled here. With bonds yielding less than inflation these days, it is a good bet that yields will normalize at some point in the future. Even if yields were to rise to 2%, bond losses will be even worse.

  15. What about tax sheltered investing in a whole life or universal life insurance product once all available TFSA and RRSP room is maxed out?

  16. What about CAB? I understand this is a bond fund that “converts” interest income into capital gains through a swap arrangement similar to HXT. This would allow (the few) people who have used up all their RRSP&TFSA room with bonds, but who still want to hold more bonds in a taxable acct. to do so at a lower tax rate (which can be triggered at a time of one’s choosing).

  17. Keep in mind that CAB does not necessarily allow you to defer taxation. Its distributions can be characterized as return of capital or capital gains, depending on the performance of the swapped fund. So, in some years you will receive significant capital gains distributions. These are still taxed more favourably than interest income, but the tax is not deferred until the time the fund is sold.

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