How important are tax considerations in investing?

Posted by on January 6, 2009 in Taxes

Starting this year, Canadians can set up a “Tax Free Savings Account” (TFSA); more details on the TFSA can be found in other blogs). The TFSA is one of the better tax structures invented by government- short of the relatively modest contribution maximum of $5,000/year and lack of credit-proofing, it is pretty much a well thought-out structure. However, as a much larger question related to structures like TFSA’s, how important are tax considerations when you invest?

Some people absolutely dread paying any taxes. Other invest without thinking of the tax consequences but what should lead what? Should tax considerations lead the product to invest in or should you invest regardless of the tax consquences? The answer, as usual, is that it depends.

Firstly, let’s start with the primer on taxation and investing. I always start with Million Dollar Journey’s posts on investing and taxes. Please note that this is a general over-view and tax rates vary from jurisdiction to jurisdiction so please do your own research.

My guiding principle on this topic is always the following quote from the book The Millionaire Next Door: “To build wealth, minimize your realized (taxable) income and maximize your unrealized income (wealth/capital) appreciation without a cash flow.” However, I would argue that one should avoid making investment decisions based on some slavish devotion to tax considerations alone and that there are degrees of sensitivities to tax implication which need to be taken into account, but not as a determining consideration, when making an investment decision.

For example, if you made a relatively modest income and had a modest risk tolerance, you wouldn’t avoid putting your money into a high interest savings account simply because you pay more on interest income than capital gains or dividends. Conversely, if you were in the high tax bracket, you wouldn’t invest in all stocks simply to avoid paying taxes on interest income in a savings account. That is just bad asset allocation.

The point being that tax considerations alone should not drive the decision on what to invest in. But you have to layer onto this some degree of sensitivity. I illustrate on a non-exhaustive basis some situations where tax implications should be taken into account when making a decision on what to invest in:

  1. People on fixed incomes: Without future earnings to off-set taxes which may be paid on investment income, individuals in this situation should be sensitive to tax implications of all investment decisions they make. Or, people approaching the clawback thresholds on government benefits, may have to assess whether potential taxable income from an investment will affect their benefits plan.
  2. People in the highest tax brackets (generally $125,000 in Canada and $358,000 in the U.S. without accounting for the AMT): At tax rates approaching 50% in some cases (when you add federal/provincial/state and municipal taxes), there should be a greater sensitivity to what one is investing in. In this situation, the maxim quoted above truly makes senses- minimize taxable income and maximize non-taxable appreciation.
  3. Self-Employed: Although able to claim legitimate business expenses against business income to minimize taxes, I include this class of persons based on experience; not enough reserves are ever held aside to pay for taxes of the owner manager (mitigated if the owner manager pays source deductions on pay day as opposed to just paying oneself a draw and paying the year’s taxes when the tax return is submitted). Receiving income from investment tends only to worsen this issue.
  4. People approaching the next income tax brackets. Taxable income from an investment may push one into a higher bracket. The jump in tax brackets can be as much as 5-7% depending on what tax bracket you are in and are going to (best to speak to an accountant about this or do some research on the web).

In the above situations, the tax considerations of the investment should be a factor. For example, if someone was in the top tax bracket and had a choice between an income trust paying interest income and a dividend paying stock, the return on investment after taxes should be analyzed carefully since, at that tax-rate, it is important to put greater weight on after-tax return.

Although I do not disagree with the Millionaire Next Door, the statement above makes the most sense if you are an upperly mobile individual with a heavy tax burden. One must always remember that tax is one of many considerations to make in investing and not the determining one.

7 Comments on How important are tax considerations in investing?

By Million Dollar Journey on January 6, 2009 at 8:19 am

Thanks for the mention TMW! Happy New Year!

By MoneyGrubbingLawyer on January 6, 2009 at 10:11 am

Tax considerations tend to factor into my decisions a little more than they probably should. While I don’t base my allocations solely on tax considerations, in choosing between similar options (for example, dividends versus capital gains) tax treatment will play a significant role. I’m also careful to keep some things like US dividend-yielding securities in my RRSP for tax purposes.

By Silicon Prairie on January 6, 2009 at 10:55 am

There are definitely bigger decisions that should come before comparing the after-tax returns of different choices. If you’re paying tax on interest every year over a long period that will have a big effect but in some situations it may be smaller – everything has to be converted to cash eventually or it’s not very useful.

By Nerd Money on January 6, 2009 at 9:43 pm

Hey thanks for the link! To be honest I haven’t really considered the tax implications of my investments other than putting my money in RRSPs and now the TFSA. I love posts that spur me on to more research.

By Weekly Dividend Investing Roundup - January 10, 2009 | The Dividend Guy Blog on January 10, 2009 at 6:59 am

[...] Tax considerations when investing [...]

By TFSA Institution Transfer Strategies on February 25, 2009 at 6:04 am

[...] of all – the tax considerations should not be the driver of your asset allocation.  The first step should be determining what type of investment (cash, stocks, bonds) you want this [...]

By adrian on October 6, 2010 at 8:19 pm

Hi there!

Regarding the TSFA I have 2 questions:
can you trade options inside a TSFA and if yes wich canadian online discount broker you recomand fot that?
How about penny stocks,warrants,debentures,pink sheets?

Write a Comment on How important are tax considerations in investing?

Subscribe

Follow comments by subscribing to the How important are tax considerations in investing? Comments RSS feed.

More

Read more posts by