How to Think About Taxes

Most people don’t spend enough time thinking about taxes.

Unlike the average Canadian, I consider myself a tax nerd. It’s front and centre in my thoughts for most of my waking hours. Now you might find that boring and weird, but it’s people like me who are trying to help people like you.

Here’s a simple example of how my brain thinks about taxes.

If I’m going to invest money outside of an RRSP, I have to consider the type of income I can expect. Basically there are four types of income: interest, dividends, capital gains and rental income.

Each type of income is taxed differently. Interest income is taxed at the highest rate, while dividends and capital gains are taxed at a substantially lower rate. We can address rental income in a later post.

Let’s say your employment income is $50,000 per year and you invest $10,000 in an interest bearing bond or term deposit through a Canadian bank. If you live in Ontario, your marginal tax rate on the interest income would be 31.15 per cent.

If that same $10,000 was invested in common shares of that same bank, the dividends you’d receive would be taxed at 13.3 per cent. If you sold your common shares for a profit at some time in the future, the ensuing capital gain would be taxed at 15.58 per cent.

Now, if we apply the exact same return to each investment (let’s use 4 per cent) your $10,000 investment would produce $400. Let’s take a look at the after tax return on your investment:

• Interest $275.40 (2.76 per cent)
• Dividends $346.80 (3.47 per cent)
• Capital Gains $338.00 (3.38 per cent)

If we project this one investment into the future, you’ll find that the tax bite (on a compound basis) will rob you of your future wealth. Right from the first year your net income is 33 per cent higher with dividends than with interest (22 per cent higher with capital gains). After 10 years, or 20 years, your net amount is still reduced by the same percentage.

So, here’s the question: What’s a bigger risk; buying a Guaranteed Interest Certificate (GIC) from a Canadian bank or purchasing common shares of that very same bank?

I’d say in the short term (up to 5 years) probably the common shares will prove to be a riskier investment. Over 10 years or more, there is a much larger risk with a bank issued GIC than with common shares in that same bank.

Here’s why: notwithstanding the additional tax taken from your interest income, your principal has absolutely zero chance of increasing in value with a GIC or bond. As a matter of fact, there’s about 99.99 per cent chance that inflation is going to erode the purchasing power of that principal.

Conversely, the common shares stand an excellent chance of increasing in value over the next 10 years. Even if they don’t, at least you stand some chance of seeing the principal increase in value.

Here’s a fun question: you’re 60 years old and don’t want to “risk” losing your money. Do you buy a GIC and live off the interest or do you buy common shares and live off the dividends? That is an extremely tough question facing a great number of retirees. The dividends on common stock are not guaranteed and the stock could wipe out your investment.

What are the chances of the Canadian bank not making money in the future and not issuing a dividend? What are the chances of the bank not being worth more 10, 15 or 20 years from now? It’s impossible to say, but there is an excellent probability that in 20 years, stock prices will be higher than they are today. What I can guarantee, however, is that the principal amount of your GIC will not be worth more.

The next time you’re considering an investment, take a moment to consider the tax consequences of that investment and where the risks really lie. Do you give the money to your bank to hold onto with the hopes that day-to-day goods don’t increase in price? Or do you put your money into a dividend producing entity with the belief that in 20 years the price will be worth more?