August 1997

After-Tax Returns

© Talbot Stevens

As an investor, you are only interested in how much you keep, not how much you share with the government. In other words, for investments outside of an RRSP, your goal is to maximize after-tax returns. Too often people focus on the gross or before-tax return.

Realize that a 100% investment return wouldn't be worth much if 98% of it was lost to taxes, leaving an after-tax return of only 2%. Even a 5% GIC beats that, as we'll see.

With a basic understanding of the tax rates for the different types of investment returns, we can identify many tax-efficient investment strategies. Ignoring minor differences among the provinces, the following table provides a simplified overview.

Approx. Tax Rates on Non-RRSP Investments
Taxable Income 0 - $6,500 $6,500 - $30,000 $30,000 - $60,000 over $60,000
Interest 0% 27% 42% 53%
Dividends 0% 7% 26% 36%
Cap. Gains 0% 20% 31% 40%
Pay Debt 0% 0% 0% 0%

Many people think there are only three fundamental types of investments, those that produce interest, dividends, or capital gains. For many of us, there is another unconsidered type of investment: paying off debts.

When we borrow for personal reasons, the interest is not deductible. If debts are for business or investment loan purposes, the interest expense is generally tax deductible.

Paying down personal, non-deductible debts is one of the best, guaranteed investments one can make.

If you are in the middle 40% tax bracket and could get a 25% GIC, the 25% before-tax interest rate would be only a 15% after-tax return, after losing 40% of the interest to taxes.

Because all personal expenses, including debt payments, are made with after-tax dollars, paying down a personal debt results in an after-tax return of the interest rate being charged.

Thus, paying down a 15% personal debt like a credit card, for example, produces the same 15% after-tax return as getting a 25% GIC.

It is clear why paying down expensive debts like credit cards is generally our highest investment priority. Most department store cards still charge 33% interest - after-tax!

Note that each year you can earn up to $6,500 of taxable income tax free, due to the basic personal tax exemption.

Regardless of your tax bracket, investments that produce interest - like GICs, savings accounts, and bonds - are taxed the most, generally the same rate as for income.

Therefore, interest income is the least tax-efficient type of investment. Someone in the middle 40% tax bracket with a 5% GIC, ends up with an after-tax return of only 3%.

While structuring our portfolio to achieve our desired goals for income, growth, and safety, we should always minimize investments that produce interest income.

Next month we will continue our discussion of tax-efficient investment strategies.

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