Net Worth Update: May 2018

Monthly Summary

In May 2018 we are still dealing with the same range bound market. This stale market environment has gone on for about four months now. That compares to about seven months for the little slide of 2015/2016 correction and around four month for the 2011/2012 correction.

There is a bright area of the market, which is interesting considering it might be the most expensive major market category in the world. Yes, U.S. small-cap stocks, trading at the 99th percentile of their historical valuation, are advancing to new highs. In the past price growth in small-caps has indicated there is some depth to the U.S. market and room for advancement. However, I don't like to count the chickens before the eggs hatch, so I'm not jumping on the small-cap trade. Instead, I'll wait until we see more growth in the bigger broad market index.

Another major factor keeping me from being more aggressive is the continuing declines in international markets--particularly emerging markets. Emerging markets are the cheapest corner of the stock world, both on a standard P/E ratio and Cyclically Adjusted P/E ratio. If there is room to grow anywhere, it would be in the Emerging markets space. That valuation growth isn't happening despite higher commodity prices and what the talking heads are calling "continued global economic expansion".

I still do not believe it's a good time to pile aggressively into the stock market. Most major market categories are not trending well, so why take the risk? I am still holding a large amount of cash and waiting for an opportunity to put that money to work.

On the brighter side, it looks like things are turning around in the short-term bond arena. If you have been sitting in cash, unsure of where to put your money, topping up your short-term bond allocation could be a good choice. My favorite short-term bond ETFs: XSB.TO, VSB.TO, and BXF.TO are all positive for the year. While BXF.TO has a higher fee than the other two, it is more tax efficient and the tax savings will more than outweigh the cost when held in a non-registered investment account.

In April, we finished the month with a total of $662,087 in our investment accounts. We were down -0.62% that month on a investment return basis. This month I once again added a regular contribution to our joint non-registered account and we eeked out a small positive investment return for the month.

I hope through sharing our real numbers you will be inspired to start saving and investing young—it pays!

The Current Numbers

Here are our current Investment Assets as of the last trading day in May. We invest in TFSAs, RRSPs, and a non-registered joint margin account. We use a version of Dual Momentum and a moving average/breakout trend strategy to determine what we buy and when we sell our ETF positions. I often employ leverage in positions, so our results tend to swing a bit more each way than the underlying indices.

January 1 of the current year is in brackets to help illustrate the change during the current year. Net Worth Change reflects the total increase/decrease of this past month including new contributions.

The Investment Return is the total year-to-date return on our investment positions, corrected for new contributions at the end of the month. Due to the end-of-month adjustment, the true rate of return on a daily adjustment basis would be slightly different dependent on the intra-month return on the new contribution.

Total Investments:  $667,450 ($670,856)
Monthly Net Worth Change:  +$5,363
30x Rule Safe Annual Income:  $22,248  ($22,362)
YTD Investment Return:  -4.90%

Background Story

My wife and I are late-20s professionals working in the public sector. We don't earn enormous salaries, but by keeping our spending under control we save a large portion of our incomes each month. Our Investment Assets are 100% the result of our own hard work and the return on investments; we have not received any gifts or won any lotteries.

While we both work in pension careers, for this purpose we don't include pension values in our net worth nor pension contributions in our savings. Our investment assets and contributions are from our net paycheques.

We invest primarily with index ETFs using a dual strategy portfolio that I personally developed and maintain. To keep our investing costs as low as possible, I use Questrade and Interactive Brokers as my online brokerages. Questrade is my go-to choice for registered accounts. Interactive Brokers offers powerful tools, low commissions, and low margin interest for our joint margin account.

Comments & Questions

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Taxation of Assets in Non-registered Accounts

In Canada our taxation system sets different tax rates for several major forms of income. With the exception of property taxes on real estate, we don't have an asset tax or wealth tax. Taxes on assets are actually charged on the income or capital gains derived from those assets in each year that income is realized.

For investors, it is important to note that we have several account-based options available to us for investing. Each account works differently and offers different tax advantages and disadvantages. In the past I have covered taxation and strategies on registered accounts such as the TFSA and RRSP.

Reduce Taxes on RRSP Withdrawals in Retirement

Proper Ways to Use RRSPs

RRSPs for Huge Tax Savings When Retiring Early

TFSA vs. RRSP vs. Non-registered Account

Now lets take a look at non-registered investment accounts (also the investment account that will be used for the Smith Manoeuvre) and how investment income is affected by taxes within this standard brokerage account.

Non-registered Investment Accounts

A non-registered investment account can go by many names depending on your brokerage. It is a standard brokerage account with no special tax treatment. Some of the names I have seen used by Canadian brokerage firms for non-registered accounts include:

  • Joint investment account
  • Individual investment account
  • Regular investor account
  • Standard investment account
  • Margin account
  • Cash account

In a non-registered investment account, any income received and all capital gains realized in a given tax year must be declared on your income tax return. This even includes interest earned on your personal chequing or savings account.This is one of the primary differences when comparing to RRSPs and TFSAs where income and realized capital gains held in the account are not reported or subject to taxation.

If you have a non-registered investment account at an online brokerage, your brokerage will typically upload a couple tax forms onto your account every spring following the end of the last tax year. These forms may include a T5 Statement of Investment Income, a T3 Statement of Trust Income, and a T5008 Statement of Securities Transactions. Each of these forms provides information that you must declare to Canada Revenue Agency on your income tax returns.

Different forms of income are taxed at different rates in Canada. There are three broad categories of income which apply to investments: Other Income, Capital Gains, and Canadian eligible dividends.

Other Income

Other Income is taxed at the highest rates of the three forms of income discussed here. Other Income includes employment income, business income, foreign income (including foreign dividends), and interest income. All these forms of income are added on top of any employment or pension income and are taxed at standard marginal tax rates for your province.

Interest Income

Interest income is the most common form of Other Income related to investments. It is often derived from bonds, GICs, or bond ETF holdings. However, it is also seen buried in distributions from REITs and real estate ETFs.

As a high tax form of income, interest income should be reduced as much as possible in non-registered investment accounts. If you need to invest in bonds in a non-registered account, choose a tax efficient bond option. This could include using a swap-based ETF such as HBB.TO which converts all interest returns to embedded capital gains behind the scenes. You could also invest in discount coupon or strip bond ETF such as ZDB.TO or BXF.TO which tries to tilt some of the bond returns to capital gains rather than interest.

Foreign Income

Foreign income is another common form of investment income which is taxed as Other Income. Foreign income is most often realized by holding foreign-listed stocks, bonds, or ETFs directly, or buying a Canadian-listed ETF which invests in foreign stocks, bonds, or ETFs for you.

The actual foreign income is the dividends or interest distributed to you by these foreign assets. Foreign income is taxed at two levels. First, before you even get the money in your brokerage account, the foreign government where the company resides taxes the distribution by way of a withholding tax that usually is in the range of 15% of the total distribution amount. Then, the remaining 85% (or so) is taxed as foreign income by the Canadian government. The foreign withholding tax cannot be avoided, except for certain countries when the foreign asset is directly held in an RRSP; however, when the investment is in a non-registered account you can claim the tax paid back on your income tax return.

Many investors misunderstand withholding tax and income tax on foreign income. To simplify, don't shy away from diversifying internationally just because of these taxes. That said, try be as tax efficient as possible by not choosing high dividend or high interest foreign investments. Aim for ETFs or stocks which pay a dividend yield of 2% or less. This caps your tax drag to approximately 0.3% per year on the withholding tax and, depending on your income level and province, around 0.5% to 0.7% on the income tax. The total tax penalty of 1% or less is still worth the diversification benefits that international investing provides.

Capital Gains Income

Capital gains income is taxed at a very preferential tax rate and has several other important advantages. First, capital gains are only taxed when you actually realize the gain. That is when you sell some or all of an investment that has gone up in value. As long as you don't sell, you are not taxed on the gain. Second, capital gains can be realized strategically to increase your cost base, which in turn reduces your future deferred taxes. Additional purchases of the same investment also increases your cost base. Finally, capital gains are taxed the same regardless of where the investment is from. This means a capital gain on a stock investment in a Canadian company is taxed at the exact same rate in the exact same manner as a capital gain on a U.S. stock or ETF investing in foreign markets.

When you do sell an investment which has gone up in value, just 50% of the profits from the sale are taxed. This is called the inclusion rate. For example, if you purchased $50,000 worth of one ETF and after ten years that position has grown in value to $100,000, when you sell you only pay taxes on $25,000. [($100,000 - $50,000)*0.5]. This means your total tax bill on a $50,000 profit would be no more than $13,500 even in the highest taxed provinces at the highest income levels.

Since an investment portfolio tilted to capital gains provides a lot of flexibility and super-low tax rates, you should often choose investment growth over investment income. Control over realizing capital gains and the limitless deferral of those gains can allow substantial compounding, tax-free wealth over long periods of time.

Canadian Eligible Dividends

Dividends paid to investors by Canadian publicly-listed companies are taxed at very preferential tax rates thanks to the dividend tax credit. The dividend tax credit is a mechanism which credits back to the investor an amount approximately equal to the corporate tax rate which the company already paid. This prevents a form of double taxation (corporate income tax plus personal income tax on the dividend).

These low tax dividends can be realized if you buy Canadian-listed companies directly on the stock exchange, or if you buy ETFs which hold a portfolio of Canadian companies.

The personal tax rates on these dividends for the investor can be very low--even negative at low income levels in some provinces. Negative tax rates can help you offset income taxes on other forms of income. If your income consists of Canadian eligible dividends only, you can effective earn nearly $50,000 of dividend income and pay zero income taxes in many provinces (B.C., Alberta, Saskatchewan, Ontario, New Brunswick, and Prince Edward Island).

However, there's a catch. Dividend income gets grossed up by 38% on your tax return before the dividend tax credit is applied. This means $50,000 in dividend income actually looks like a $69,000 income. Be careful about earning a large amount of dividend income because it could impact your benefits including Child Benefits, OAS benefits, and GIS benefits among other provincial social security benefits resulting in much higher true tax rates than you think.

Summary

You will almost always being paying some income taxes when you have investments in a non-registered investment account. However, a portfolio tilted towards capital gains and Canadian eligible dividend income will still be highly tax efficient due to low tax rates on these forms of income.

If you are very efficient in your investment strategy in a non-registered account, you can expect taxes to reduce your investment returns by approximately 0.5% per year. That relatively small cost is well worth the diversification, flexibility, and investment benefits that broadly diversified portfolios in non-registered investment accounts can provide.

Generally speaking, non-registered investment accounts are not the best place to engage in frequent buying and selling, investing in bonds or GICs, or investing in high dividend foreign stocks or ETFs. These strategies or assets can be impacted by much higher tax drags and meaningfully reduce your overall returns.

Read my tax allocation article and list of favourite ETFs to get some ideas of what to put in your non-registered investment accounts to remain tax efficient.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.