Tax Smart Investing

Recently, Moshe Milevsky published his most recent research on The Impact of Personal Income Taxes on Returns and Rankings of Canadian Equity Mutual Funds. His findings were very interesting and any investor with money invested outside the RRSPs should be conscious of his findings.

The importance of after tax returns

If we had two investments, one offering returns of 10% and the second offering returns of 8%, which would you choose? This is not a trick question. The answer is that most would choose the 10% investment with all other factors being equal. However, if the first investment produced an after tax return of 6% while the second investment produced returns of 7%, which would you choose now?

The old saying goes, “It's not what you make but rather what you keep that counts”. This is especially true in the investment world. Consider that two thirds of all investable wealth in Canada is outside of registered plans like RRSPs. In the Canadian Mutual Fund industry, 54% of the assets are held outside of RRSPs. In dollar terms this represents almost $200 billion dollars. Add in the fact that we are going to go through the trillion-dollar transfer through inheritance and you've got a pretty strong case for after-tax investment awareness.

How much is lost to taxes?

In Milevsky's study, he concludes that on average 1.35% is lost to taxes from annual distributions alone. Before tax, the average annual return for mutual funds with a 10-year history (343 funds) was 9.01% percent. After distributions, the average return was 7.66%.

He further concluded that tax is triggered not only by the fund manager's activities, but also when investors dispose of the funds. He added that on average another 1.0% is lost because when the investor disposes of the fund.

Understanding tax efficiency

In technical terms, the average tax efficiency was about 85% based on the fund manager's activities within the fund. An 85% tax efficiency ratio simply means that the investor got to keep about 85% of the pre-tax return and 15% of the return went to taxes.

In Millevsky's research, the highest tax efficiency ratios were 100% before disposition by the investor. There were 54 funds out of 343 funds that achieved this highest distinction.

On the flip side, the worst tax efficiency ratio was 25.31% which means that investors got to keep about 25% of the pre-tax returns (or giving 75% of their returns to taxes).

Ranking the results

When Milevsky compared the rankings of 343 mutual funds performance before taxes compared to the rankings after taxes, the results were astounding. Fifty percent of the funds moved more than 19 spots comparing pre-tax returns to after-tax returns. For example, the biggest change occurred with the Montrusco Bolton US Index Fund, which ranked 66 best performance out of 343 funds before tax. When taxable distributions were taken into account, this fund dropped to 251 out of the same 343 funds. This fund's ranking moved 185 positions.

According to this study, the number 1 ranked pre-tax return was the Multiple Opportunities Fund with a 21.58% return. However, on an after tax basis, it ranked fourth overall with a still respectable 14.45% return.

The top three ranked after tax returns came from the Formula Growth Fund, the AIC Advantage Fund and the Maestral Quebec Growth Fund.

The bottom line

If you are looking to invest non-RRSP money, it is crucial that you are aware of the implications of tax. The biggest problem in the industry today is that we post pre-tax returns and not after tax returns. This may change one day but for now there is very limited information available regarding the tax efficiency of funds.

Currently, some financial advisors can access tax efficiency data through PalTrak by Morningstar but caution must still be applied because there are still some inconsistencies in the data. For retail investors, this information is near impossible to find. Until the regulators make after tax disclosures mandatory, the accessibility to this information will continue to be quite limited.

Next week, we will take a look at some of the things investors can look for to make their portfolios more tax smart.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

3 Responses to Tax Smart Investing

  1. Great piece! It truly is amazing how much can be lost to taxes! I try to invest the less tax efficient mutual funds, such as REITS and bonds, in my tax deferred investment accounts.

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