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Minimizing Investment Costs: Taxes

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In my post, Compound Return Investment Lessons [4], we explored how the principle of compounding can impact portfolio returns.

One lesson; by minimizing money spent on taxes and transaction costs, the amount available for reinvestment increases. And it is the reinvested money that is critical to successful compounding.

So what can you do to try and maximize your cash return? Let’s look at reducing taxes first.

Note that specific tax solutions are based on an individual’s unique circumstances. What is discussed here is general in nature and you must assess your personal situation before taking any action.

Tax-Deferred Income Accrual

Where available, a tax-deferred account should be your primary investment vehicle. Depending on where you live, that might be an IRA (US), RRSP (Canada), ISA (UK), etc.

In certain countries, there are tax-deferred vehicles that allow contributions with after-tax dollars. So you are not taxed on your paid-in contributions when withdrawals are made. Roth IRAs in the U.S. are one example. However, we shall just consider the plain, vanilla tax-deferred accounts today.

Income earned on investments in these accounts should accrue tax free, hence the term tax-deferred. You only start being taxed when you liquidate the account or begin making withdrawals. Then you are taxed on the entire withdrawn amount.

Consider two investment accounts, one taxable (i.e. normal), the other tax-deferred. In each, you invest $4000 every year end and earn 8% income annually. Your effective tax rate is 30%.

After 10 years, the taxable account grows to $53,000. But the tax-deferred account is worth $58,000.

Paying taxes reduces the amount of money that you can reinvest and compound. Your return is reduced by the tax impact in the non-sheltered account. And the higher the annual return, the more your money compounds.

Potential Tax Deductions on Contributions

Investing through a tax-deferred investment account, you may be eligible to a tax deduction for some or all of your contributions. Rules vary between countries, so check the specifics where you live to see if you can claim a deduction.

Why does the government allow you a tax deduction to invest? Because when you take the money out of the account you are taxed on the entire withdrawal, not simply the income earned.

In a Canadian RRSP, you make $4000 in annual, year end contributions over a 10 year period and earn an 8% annual return. This results in $18,000 in interest, dividends, and capital on your investments. In year 11, BMW decides to have a huge sale on cars. You liquidate your RRSP to spend that $58,000 on a car. Unfortunately for you, the government will tax you on the entire $58,000. Not just the $18,000 you earned. Assuming a 30% tax personal rate, only about $4o,600 is left for your car purchase. So much for the upgrades.

In a taxable account, you are only taxed on income that you earn. Under the same investment pattern as above, you end up with $53,000 in your account due to having to pay tax on the income each year. But when you liquidate the account, the full $53,000 is yours to spend as you please.

Hey, wait a minute! I thought that tax-deferred accounts were supposed better than normal ones.

It is, just keep reading.

Time Frame is Crucial

Remember, the longer the time frame, the greater the impact of compounding. By terminating a tax-deferred account early (and paying tax on everything in it, including your contributions), you hurt yourself by not letting the money compound tax free. In our example, 10 years of compounding is not long enough to offset the taxes owing when you liquidate.

But let’s say you skip the BMW and continue investing at $4000 per year, earning 8% annually.

After 30 years, the RRSP grows to $453,000, the taxable account only $316,000. After 40 years, your RRSP sits at $1,036,000 while your normal account is only $619,000.

If you liquidate the RRSP and pay 30% tax on everything, including your own contributions, you net $317,000 in 30 years. After 40 years, you net $725,000. In both scenarios, you are better off with the RRSP than the taxable account. And, the longer the time frame, the greater the difference.

Government “Contributions” to Your Tax-Deferred Account

I stated above that your contribution may be eligible for a tax deduction.

A 30% effective tax rate translates into $1200 less tax than you would otherwise pay each year for your $4000 contribution. In essence, you only need to save $2800 in real money and the government through the tax deduction you claim, “contributes” the remaining $1200 to reach the $4000.

Had you invested only $2800 (your own out of pocket contribution) in a normal account each year, you would have even less assets in the future. After 30 years, only  $221,000. After 40 years, only $433,000. So by contributing $2800 of your own money and using the tax refund on the deduction for the rest, you end up with a lot more bang for your buck. Liquidate in 30 years and pay tax on everything, you still net $317,000. After 40 years, $725,000.

Timing of Contributions is Important

When you make your contributions also helps your returns.

In the examples, we assumed contributions were made at the year end. That resulted in tax-deferred values of $453,000 and $1,036,000 after 30 and 40 years respectively. Had you managed to contribute at the start of the year, your valuations would be $489,000 and $1,119,000. For no additional money out of your pocket, you would have made $83,000 more after 40 years. Not bad for doing nothing.

Why Have a Taxable Investment Account?

Often there are annual limits on the amounts that individuals can contribute to tax-deferred accounts. This may be an absolute amounts and/or may be based on income level. If you want to invest more than the annual contribution limit, you may need to set up a normal, taxable investment account.

In many countries, different types of investment income (i.e. interest, dividends, capital gains) are taxed at different rates. Consider using a tax deferred account to hold your highest taxed investments (usually interest income) and keep the lowest taxed investments (usually capital gains) in a non-tax deferred account.

That is enough for now.

If you have not yet set up a tax-deferred account, I hope this will provide the motivation to do so.

Next up, potential ways to reduce transaction costs.