The 2 largest external factors eroding your net worth

Posted by on January 13, 2010 in Taxes

There is justifiably a lot of attention paid to the effects of fees on investment returns particularly MER charged on mutual funds and ETFs. While in no way should it provide a defense to high-fee products, this focus, taken to a myopic level, can obscure the two largest external factors eroding your net worth.

Taxes and inflation.

There are already many wonderful summaries of the tax consequences of each type of investment. Suffice to say, the general rule is this: low risk, low upside investments (think high interest savings accounts, GICs, T-bills, Bonds) tend to attract higher taxes than higher risk, higher upside investments (stocks, real estate (on sale and not rental income), investments in private business) which tend to attract lower taxes. The government does this on purpose. As an industrial policy, it wants to encourage taxpayers to invest in innovation and risk.

Stopping or slowing the tax leakage in your net worth, comes down to answering two questions:

  1. WHAT are you buying? Is it, based on the totality of your income streams, increasing the tax leakage or lessening it? For example, assume you are at or near the top of the personal income tax bracket and all of your income and investments are cash/cash equivalents (high interest savings account, money market funds, income trust distributions characterized as income). Would you invest surplus cash into another vehicle that is taxed as income, potentially pushing you into a higher tax bracket and keeping less and less of each dollar earned? The more tax efficient approach may be to invest in products that pay dividend income or are eligible for capital gains tax.
  2. WHERE are you buying it? Tax inefficient products (see above on low risk, low upside investments) bought outside of tax deferral plans (RSP, TFSA, 401(k)) erodes net worth. (as a side note, as an accountant said to me, it is interesting that the TFSA should ideally be used for stock market speculation given the gain is entirly tax free but the average investor opts instead not to fully top up their RSP and divert funds to the TFSA to buy money market funds. Certainly food for thought).

The Millionaire Next Dollar observed that taxes paid constituted 12.9% of the average American household’s income but the millionaires they studied had a rate at a mere 6.7%. How? To paraphrase the authors, average households carry too much cash or near cash equivalents which are eroded by taxes while millionaires tend to be invested in appreciating assets which are not taxed until sale.

Finally, in Stocks for the Long Run, Jeremy Siegel noted that real returns after taxes for someone making $50k based on returns for the period of 1913-2006 were 4.4% (stocks), 0.5% (bonds), -0.6% t-bills, 0.4% (gold). In other words, the tax inefficiency of fixed income over stocks becomes glaring over time which does not/should not concern an elderly investor with shorter investing horizons but is quite damaging to the shell-shocked middle aged investor parked in cash in a non tax-deferral account.

Inflation, the erosion of a dollar over time, is an equal opportunity eroder of wealth. Over the short term, there are few vehicles which truly can combat inflation. Real return bonds (or TIPS) are effective but its utility is diminished if it is held in a non-tax deferred account since the tax leakage has de facto inflationary effects on return.

Over the long term, some argue certain types of stocks are ideal to fight inflation. However, as history proves, over the medium term, high inflation can defeat stock market returns. Consider the period of 1966-1981, the Consumer Price Index, a measure of inflation, ran at 7.0 and the real return on stocks (return after inflation) was -0.4%.

However, during the same period, the real return on fixed income was -4.2%. If you made $50,000 during that period, after tax return was -6.1 which is a triple indignation since one could have bought government debt via a t-bill or GIC, received a real return which was negative and then get taxed on that return; the government got your money twice and you lost money!

What does this all mean to you?

Where stock market returns are modest, tax leakage and inflation can and will turn modest paper gains into losses. A flight to safety in uncertain times is a prudent tactic to adopt but as a long term strategy, as the above slows, at the wrong age and for the long length of time, it can actually move your net worth backwards.

What should you do?

  1. Speak to your accountant about tax leakages in your portfolio. Don’t ask her if buying Apple was smart. She is not qualified to answer that question. She is, however, qualified to say where ideally any stock you buy should go or what should go into tax deferral vehicles. Looking at your life structurally for tax leakages is an often over-looked benefit of a good accountant.
  2. Be aware of the effect of inflation on your returns. A 8% paper gain may sound great but if inflation is at 4%, the real return is actually 4%.  Hard assets, stocks of companies that can pass on cost increases to customers, inflation-protection fixed income products in moderations are products which should be studied to see if they fit within your portfolio.

The point is not to structure one’s life solely to pay less taxes and combat inflation. However, they should be factors which need to be paid attention to by most investors.

Best of luck.

4 Comments on The 2 largest external factors eroding your net worth

By on January 13, 2010 at 8:42 am

Rarely does it make sense to buy stocks or other investments outside of retirement account unless you have maxed out your allowable contributions. I see so many people investing in stocks while not contributing to their 401(k). That makes no sense to me.

By Friday Links - Canadian Finance Blog on January 15, 2010 at 6:18 am

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By Best Dividend Stock Investing Posts of the Week – January 16, 2010 on January 16, 2010 at 3:19 pm

[...] 2 largest external factors eroding your net [...]

By Junkers on January 19, 2010 at 9:01 am

What can be done then — looking at another 66-81 type tax & waste system coming at us in the USA? Buy gold (chuckle) I know it does worse than even stock returns… buy farm land? Houses, etc. REITS? I feel like I’m stumbling around like many trying to find where to put this years contribution, thanks!

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