Tax Efficient Investment Planning (1/n)
Summary
This is the first post in a series intending to teach you how to implement a tax efficient investment policy.
TODO: disclosure
As any good accountant will tell you, “the easiest way to pay less tax is to make less money”. While this is obviously a fools errand, there is some truth to it.
Deriving income through investments is a privileged position. Unlike employment and most business income, clients retain some control over when and how their investment income is realized.
Why do we care about this? Taxes are the largest performance drag for most investment portfolios. Unfortunately, it is far too often treated as an afterthought. How can a portfolio manager assess the merits of an investment for a client without knowing its expected after-tax return?
It is due to this insight that accountants, portfolio managers, lawyers, and of course, their clients should be working together to achieve a holistic tax and investment plan. Far too often, each of these stakeholders operate in a silo, unaware of each others objectives and constraints. The only way to achieve a globally optimal plan (in expectation) is to solve for all of these competing objectives at once. # Note 1
What are the clients goals, what does the estate plan look like, what is the current tax position of the stakeholders, and is the current investment policy consistent with the clients goals? As a portfolio manager, what is our role in all of this?
Note 1: A problem that constraint satisfaction solvers are particularly apt for.
Concepts
We will start off with two basic concepts: tax deferral, and absolute tax savings.
Tax Deferral
Why defer tax if the bill must be paid in the end?
- Once deferred, we preserve the option to achieve absolute tax savings in the future.
- Deferral in and of itself may achieve absolute tax savings.
The market doesn’t give out free options often, so we should strive to take advantage of them when it does. For example, a high income professional may be in the maximum bracket today, but could be in a much lower bracket in the future. This is one of the primary purposes of the Registered Retirement Savings Plan (RRSP).
On the second point, we can show mathematically that deferral can achieve absolute tax savings in and of itself.
For example, let’s assume we have an investment earning the market total return including dividends Rm. Now we have two investors in an identical tax bracket T. In the first case, the investor defers their tax for n years, realizing the full amount at the end. In the second case, the investor realizes the tax every year.
What is the difference in after-tax returns between these two investors?
The first investor receives (1+Rm)^n(1-T). The second investor receives (1+Rm(1-T))^n.
The difference in percentage return between these two investors can be modelled as:
(1+Rm)^n(1-T) / (1+Rm(1-T))^n - 1
We present a chart below plotting this difference.
TODO: CHART
As we can see, at short horizons the two options give very similar results, but at intermediate and longer-term horizons the tax deferred investor pulls ahead.
Absolute Tax Savings
Absolute tax savings arise when you are able to lower the total amount of tax paid. This can happen for a variety of reasons, including but not limited to:
- Registered Accounts (yes, even your RRSP)
- Using the progressive income brackets
- Appropriately structuring your estate plan
- Using the lifetime capital gains exception for a qualified farm or business
- Earning income through capital gains instead of ordinary income or dividends
In this post we will focus on only the RRSP.
How can investing in an RRSP result in absolute tax savings when you have to pay at your maximum marginal rate (in most cases) when money is withdrawn? An RRSP actually combines a deferral (since RRSP contributions are tax-deductible), and absolute tax savings since any investment income in an RRSP is free of tax (ignoring foreign withholding and other special circumstances).
The ideal outcome for an RRSP is that you contribute and take the deduction during your working years at a high rate, earn investment income free from tax, and then withdraw from the RRSP in a lower tax-bracket. Some people get caught up on that last point. What if your income in retirement is higher, or what if tax rates are higher when you’re making RRSP withdrawals? This is a valid concern, nobody wants to defer into a higher tax regime.
It’s easier to see the absolute tax savings if we ignore the deduction and deferral and only focus on the investment income. Can we actually achieve this in practice? Yes, when you make a contribution to your RRSP, you don’t have to deduct the tax in that year. You can carry the deduction forward indefinitely. # TODO: Confirm
Okay, but now we have RRSP contributions that will be taxed on withdrawal right? Nope, ** THINK THROUGH THIS MORE WITH EXAMPLES **
Citation
@misc{dale_koepke2024,
author = {Dale Koepke, Brandon},
title = {Investment {Tax} {Planning}},
date = {2024-12-06},
url = {https://finitemoment.com/posts/investment-tax-planning/},
langid = {en}
}