Last week, we talked about some new research by Moshe Milevsky on the importance of Tax Smart Investing. This week, I want to look at some of the things investors can do to try to be tax smarter when it comes to investing.
- Look at Tax Efficiency Ratios. Ask your financial advisor if they have access to Morningstar's Paltrak software program. If so, they will have access to some of the only tax efficiency data in Canada. As I mentioned before, tax efficiency data in Canada is really tough to come by and even if you can access the data, it is not perfect. However, some data is better than nothing.
Tax efficiency simply tells us how tax efficient a fund has been in the past over a 3, 5 or 10 year period. The trouble is that tax efficiency, like performance, is not a perfect indicator of how tax efficient a fund will be in the future. Despite the imperfections, tax efficiency data is the best data we have in the mutual fund industry to understand the after tax implications of investment income and trading.
- Investment Income (Capital Gains vs. Dividends vs. Interest Income). There are three basic types of investment income. The least tax efficient income is interest income. Buying fixed income investments has certain safety and income benefits, but they typically lack in tax benefits.
On the other hand, investment income can come in the form of capital gains or dividends. Both of these types of investment income are tax preferred over interest income. Understanding the type of investment income from your investment can go a long way in getting the tax advantage.
- Is the Manager Tax Smart Conscious? In the past, mutual fund managers were primarily focused on making good investment decisions to get the best performance for the least amount of risk. Today, there is a new breed of mutual fund manager that not only looks to achieve good performance but deliver it with tax efficiency. By controlling turnover and tax loss selling, managers can give the extra edge when it comes to tax efficiency.
- What is the Turnover? The turnover of a fund refers to the amount of trading activity that occurs in a fund. Every time a mutual fund manager sells a holding to buy a new one, it creates turnover. In most cases, a higher turnover means more taxes since every trade creates the potential for triggering capital gains. It may be in your interest to look for funds with a low turnover of holdings.
- Corporate Structure Funds. Most mutual funds in Canada are structured as a trust as opposed to a corporation. With respect to taxes, the advantage to a corporate structure is the ability to allocate investment income among the different corporate classes and also defer investment income when switching from fund to fund. Corporate class funds are ideal for investors who like to trade investments from one fund to another. Tax deferral is a terrific tax smart investment strategy.
- Buy and Hold Strategy. We talked about investment turnover by mutual fund managers. However, turnover can also be controlled by investors. Investors who practice the buy and hold strategy benefit from low turnover and thus defer tax.
- Tax Loss Selling. Invariably, every investor will lose money on his or her investments from time to time. When this happens, investors can use these losses to their advantage by deferring gains in the future. Capital losses can be used back three years or forward indefinitely.
- Keep Interest Income in Tax Sheltered Plans Like RRSPs. Every investor who practices the principle of diversification is likely to have both fixed income and equities in their portfolio. When possible, it may be in their advantage to invest fixed income investments inside tax sheltered plans like RRSPs. That way inefficient taxable investment income like interest income is tax deferred. At the same time, investors can take advantage of tax efficient capital gains and dividends outside the RRSPs.
Just when you thought the investment industry was complicated enough, add in tax smart strategies and we've got more confusion than ever. That being said, making good tax decisions is just as important as making good investment decisions. Make sure you do your part in being tax smart.