Mounting tax bills compounded by high inflation are creating financial challenges for many affluent Canadians. To help clients in this difficult environment, investment advisors must abandon today’s prevalent approach of balancing pre-tax returns and risk, and adopt a new paradigm that integrates portfolio and investment tax management. This new approach seeks superior after-tax returns to suit each client’s unique blend of objectives, risk capacity and tolerance, and tax profile.
Portfolio construction under this paradigm incorporates five critical items.
- After-tax portfolio design
First, design asset mixes based on expected long-term after-tax returns. Portfolio optimization that seeks the highest after-tax return for a specified level of risk will result in asset mixes that vary from those based on the traditional pre-tax model.
For example, the lower tax rate on eligible dividends from Canadian companies versus fully taxed foreign dividends will mean an increased allocation to Canadian equities relative to foreign equities, other things being equal. For income-oriented investors, a moderate allocation to Canadian preferred shares is more tax-efficient than using only fully taxed bonds.
Another example is real estate. The capital gains and non-taxable return of capital distributed by Canadian REITs enhances their after-tax return potential relative to more highly taxed global REITs.
- Purposeful asset location
Second, allocate assets to locations that reduce taxes. For affluent households, asset locations often include not only taxable accounts, RRSPs and TFSAs for both spouses but also RESPs, children’s accounts, life insurance, trusts and corporate entities.
The tax characteristics of each location must be mapped. Asset location decisions can be impacted by a variety of factors including tax rates and loss carryforward balances, savings and withdrawal rates, short-term liquidity requirements, unrealized capital gain balances, shareholder loan and capital dividend account balances, U.S. tax and/or U.S. estate tax exposure, charitable giving, potential alternative minimum tax exposure and multigenerational plans.
Consider TFSAs, for example. Since TFSAs generate permanent tax-free returns, they are often best utilized for high-return vehicles that are fully taxed in non-registered accounts, such as high yield bond, mortgage and private credit funds.
Conversely, since investment management fees are not deductible in a TFSA nor are foreign withholding taxes recoverable, non-Canadian equity funds, particularly those focused on dividends and/or with high fees, are typically a non-starter.
Another example is family trusts when children with low tax rates are the beneficiaries. Since the tax advantages of Canadian eligible dividends are magnified at lower tax brackets, equity allocations to a family trust typically include a greater proportion of Canadian preferred shares and high dividend Canadian equities.
- Manager and investment selection
Third, evaluate and select managers and investments based on their long-term expected after-tax returns. Since attractive pre-tax returns grab the headlines, it is easy to forget that it is after-tax returns that fund consumption. There can be a gaping difference between a fund’s pre- and after-tax returns depending on its investment strategy, legal structure and trading activity.
Tacita Capital’s research team compared the pre-tax and after-tax pre-liquidation returns of U.S. equity mutual fund share classes as reported by Morningstar over the past five years. Based on Morningstar’s tax-cost ratio, the quantum of annual return lost to taxes ranged from a very attractive 0% to a staggeringly expensive 7.0% a year. More than one-quarter had a tax cost of more than 2% per annum. For many affluent investors, tax costs matter as much as or even more than management expense ratios.
- Tax-efficient rebalancing
Fourth, investments are traded with an eye on tax efficiency. Rebalancing parameters should be carefully set to avoid needless trading due to moderate short-term volatility. The portfolio’s income streams should be used to rebalance before triggering taxes through the sale of appreciated securities. Tax-loss harvesting should also be undertaken when economical.
- Collaboration with client’s accountant
Fifth, collaboration with a client’s accountant is key. Tax planning is an ever-changing specialty that goes beyond investment tax management and includes such functions as tax return preparation and filings, CRA dispute resolution, capital dividend tracking and election filings, salary/dividend analyses, trust planning, probate fee minimization and estate freezes. By coordinating portfolio and investment tax management with the advice and planning of the accountant, a comprehensive approach to tax reduction can be successfully implemented.
Taxes for the affluent are likely going only one way: up! Advisors must adopt a new paradigm of portfolio management if they are going to meaningfully assist their clients in achieving their goals in today’s tax reality.
Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.