Wednesday, December 29, 2010

After Tax and Inflation Returns on Stocks

Previously we compared the after tax and inflation returns (ROITI) of a plain interest bearing investment. It was concluded that the use of TSFA vs. RRSP accounts was dependent on the financial situation of the individual investor as well as whether we were in an regime of rising or falling income taxes and inflation. A typical fixed-income investment yielding 5% resulted in anemic real after tax returns.ROITI). Top tax margin rate investors and low margin rate investors who over time moved into higher tax brackets were most like to lose money in RRSPs while returns in TSFA were not tax bracket dependent.

In this posting we look at ROITI for stocks. We look at this year's performance and the long term performance based on data from Jeremy Siegel's "The Future for Investors". Last year's S&P TSX60 stock index returned approximately 11.5% appreciation plus an average dividend yield of 2.6%. Over the last 200 years the average stock market return including dividends was 11.18% assuming an average dividend yield of 2.5% that means appreciation was around 8.7% annually. Jeremy's real stock return is 6.5-7% implying an average inflation of 4.3%.

Those are the numbers entered in the Excel spreadsheet below:

The yellow fields on the spreadsheet let us enter our assumptions. Based on Alberta's 2010 income tax data, the top marginal tax rate is 39% - i.e. the maximum tax rate on salaried income or interest income. Rental income would be taxed at this rate as well. However, this income can be deferred using the depreciation (CCA). Capital gains are taxed at 50% of the marginal tax rate. Dividends in Canada are the most difficult to calculate. Basically the actual dividend income is first increased by 'gross-up' factor which can be changed annually. Next the dividend tax which is the grossed-up dividend yield multiplied with the top marginal tax rate of the investor. Then a tax credit is deducted which comprises a provincial and a federal tax credit rate multiplied with the grossed-up dividend. The result is the dividend tax payable. After all is said and done, in Alberta the dividend tax rate is less than the marginal rate ranging from -4.02% for the lowest tax bracket to 15.88% for the highest bracket. If you have a significant amount of investments, it is certainly worth your while to sit down with your account and figure out what investment type provides you the best returns and cash flows.

The spreadsheet shows you what your after tax and after inflation returns are on stocks when you are in the top tax bracket in Alberta. In most other provinces your returns are likely poorer. Stock investment profits are derived from two sources: Appreciation (capital gains) and dividends (cash flow). Both profit types are taxed differently and both lose purchasing value over time due to inflation. To calculate your return on a stock investment of say $100 in 2010 with a return equal to that of the TSX60 index, you have to determine both appreciation and dividend income. That is $100 x 11.5% plus $100 x 2.5%, i.e. $11.51 and $2.60 respectively. Taxes due on those returns are 11.51x0.5x39%= $2.24 (top marginal tax rate) for the appreciation plus $2.60*15.88% = $0.41 on the dividends. Total after tax income is: $11.51+ $2.60 - $2.24 - $0.41 = $8.85. In other words, you paid 19% taxes on your total income of $11.51 + $2.60 = $14.11. If you had earned $14.11 through employment you would have to pay 39% taxes instead.

So you made last year $8.85 after tax, but there was also a bit of inflation. Your $8.85 at year's end was worth 1.9% less than it was at the start of the year. Also, the purchase power of your $100 investment money lost 1.9% in purchasing power. So after inflation you only made $6.82 or an after tax and after inflation return of 6.82%. If you had put the same money in an TSFA you would not have to pay taxes on your investment income but you would have lost some of that income due to inflation. After inflation your profits would have been $9.43 on a $100 investment or 9.43%. Unfortunately, you are only allowed to put a maximum of $5000 of your savings per year in your TSFA. The rest you have to keep in a normal investment account or... in an RRSP.

Clear as mud! Yes Sir, 5% interest bearing investments with a 1.55% ROITI clearly doesn't cut it. But... in 2008 you probably would have howled differently, wouldn't you? Yes, of course, stocks are much more volatile than fixed income and if you panicked and sold your stocks at the bottom of the bear market you lost a lot more than only earning 1.55%! That is why we always tell you that stocks are for the long run. Here is where Jeremy Siegel's work proves to be so valuable. Jeremy found that if you held stock over the last 200 years and always re-invested your dividends, your return on investment would have averaged 11.2% per year comprising of 8.7% appreciation and 2.5% dividend yield. We have discussed this elsewhere in this blog and we will not go here into more detail.

How would Jeremy's returns have worked for the top margin Alberta investor in a non-sheltered investment account and how would that compare when held in a TSFA or in a RRSP? The answer, my friend, is blowing in the wind or in the above spreadsheet. You chose. His returns for the regular investment account and the TSFA are similar to that of the one year calculations and result in an annual ROITI of 5.81% and 6.62% respectively. Returns for the RRSP are a bit more complex. $100 invested in an RRSP is pre-tax money and thus if you invest $100 of your after tax savings, you get a tax refund equal to $100 x top marginal tax rate or $39 in Alberta. This of course makes life more complex. Not only do you have to pay taxes at your marginal tax rate (39%) when you withdraw both your investment and your profits from your RRSP, you also have to decide what to do with the tax refund.

In our earlier posting "The Struggle of Tax Shelter Giants" we assumed that your tax refund was not invested, instead of $100 you invested $71 after tax dollars. In the spreadsheet above it was assumed that you invested $100 after tax dollars or $100 within your RRSP and the $39 refund you invested in a regular investment account in the same stock investment. So other than taxes, you invested with the same return and inflation rates. For 20 years you see the worth of your RRSP outperforming the non-tax sheltered and even the TSFA returns, but when you withdraw your RRSP money you have to pay the piper! Every penny you withdraw is at you marginal tax rate which if it hasn't changed over the years is... 39%. When combined with the after tax returns on your regular account, you pay close to 36,4% in taxes and your after tax return falls between that of the TSFA and a regular account. Then you get hit by your loss in purchasing power and on an after inflation basis, your ROITI is 6.05%. That is better than a non-sheltered investment in stocks but worse than a TSFA. Pity you can only put $5000 in your TSFA, but you have still a lot of shelter room left in your RRSP before you need a regular account. With a long term investment, stocks on an after tax and after inflation basis will outperform fixed income investments every time. What does destroy those returns is selling in stock market crashes and investing in just a few stocks rather than a diversified portfolio.

BTW since we are expecting inflation and taxes to go up over the coming decade or so, the top marginal tax rate is likely to go up as well. This will not only reduce you returns on your regular investment accounts, but also on your RRSP investments. The returns on your TSFA will not be affected.

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