Keeping More of what you Earn
The Financialist • Issue 133 • April 2017
BY CHRISTIAN WHITE BA CFP
You’ve saved long and hard for many years. You’ve made sacrifices and put your long-term needs ahead of your current desires for that vacation, the newer car or upgrading the kitchen. All this was done so you could achieve your planned level of retirement income needs.
Now that you may have made it to this new milestone – Retirement – there are still another set of hurdles that you need to overcome to ensure that you do not run out of money before you run out of life!
Retirement income planning has many facets that need to be addressed, such as maximizing your government benefits, minimizing your current and future tax rates, as well as ensuring that you have your assets positioned to protect from markets downturns.
The area that tends to be overlooked is ensuring that your assets are as tax-efficient as possible. This means you keep more of what you make in your jeans. It also means that your after-tax returns are far more important than your pre-tax returns.
If you could look back over the investment cycle of two different investment options (you can only choose one): Option one pays you 7% taxable and option two pays you 6% after tax, which one would you select?
There’s an old saying that I have heard from a number of accountants that I work with: “It is not how much you earn that matters, but how much you keep that matters”. Step one is to have a basic understanding of how different sources and types of income are taxed. The most common sources of retirement income today come in four forms:
2. Capital gains
4. Return of capital
Interest income is taxed just like your paycheque. This type of income is considered 100% taxable in the sense that there is no tax relief. GICs and most types of bond income are considered interest income. The benefit of this approach is that most vehicles that produce interest income do so in quite a steady fashion. This is usually the number one reason why a properly allocated retirement income plan will hold a portion of the portfolio in this asset class. The disadvantage to this approach is that rates have been quite low for a number of years, thereby not protecting the purchasing power of your money over time.
Capital gains income is currently taxed at half the rate of your paycheque or interest income. This type of income is considered 50% taxable. For example, on a $1000 gain, only $500 is taxable. Typically a capital gain is deemed to have occurred when property is sold that has appreciated in value such as securities, ETFs and mutual funds. Bonds have the potential for capital gains as well, if they are sold above their purchase price prior to maturity. The benefit of utilizing this approach within your retirement income plan is that you get to keep more of the total return than you would using an interest income-focused approach. The disadvantage to this approach is that most capital gains-producing investment vehicles have volatility (more risk) in the underlying assets.
Dividends: There are a number of different types of dividends such as eligible, ineligible and foreign dividends. The most common types of dividends in a retirement income portfolio are dividends from Canadian publicly-traded companies. The government recognizes that it’s unfair to tax the same income twice. So they give you a break on dividend taxes to offset the taxes the corporation already paid. This is called the “dividend tax credit”. It works by grossing up your dividend income and then applying a credit to you. This ensures that the tax paid by the company distributing the dividend is accounted for so there is no double taxation. Depending on your level of income, dividend income can provide a significant value. One benefit is that a number of high-quality Canadian dividend paying companies have track records of paying a positive dividend for 85 years or more. Plus, you keep more of the total return as less income is added to your total taxable income. The disadvantage is that, to be able to utilize the dividend tax credit to its utmost, you must invest in Canadian publically-traded companies. This isn’t much of an issue, as a properly allocated retirement income plan would call for these vehicles in a percentage based on your age, income needs and appetite for risk.
Return of capital is not something new to the financial planning world. However, it has become more and more popular as there are products that make access to this type of income more available to investors of all types. Return of capital is exactly that, return of your after-tax invested dollars thereby attracting zero taxes in the year it is paid out. Sounds too good to be true? In the process of paying out income that has no tax, these programs keep the taxable gains in the investment and defer it until a later date. In some cases, only taxable in the year of your death or in the year of the death of the second spouse. Return of capital can provide some tax benefits today but deferring all the taxable gains until the terminal tax return can mean a hefty tax bill for the estate.
There are benefits to all types of income and each type of income has its place in your retirement income plan. The question shouldn’t be what is the best and only type of investment to hold to maximize your retirement income. The question should be in what type of account you should hold these vehicles? In what percentage based on your goals, age and appetite for risk should you own them? Over time, you will more than likely receive income in all four forms when properly diversified to reduce risk.