Capital gains tax: The real enemy of your investment returns

The real enemy of investment returns

Pundits say the Feds might boost capital gains tax rates this year

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The Federal budget rumour mill is ramping up and word has it that savers will be asked to pay more. Some pundits think that the tax rate on capital gains will be kicked into overdrive this year.

Problem is, taxes already cut deeply into investment returns. To illustrate the issue I’ll walk through a simplified example.

I’ll start with the Canadian stock market, which has been one of the best performing markets in the world over the very long term. As measured by the S&P/TSX Composite index, it turned each dollar invested into $23.84 from the start of 1980 through to the end of 2016. That amounts to an average annual return of 8.9% but that figure does not include fees, taxes, inflation, and other frictions.

If one applies a 27% tax on gains annually to the market’s returns, the results aren’t quite as good. (The 27% rate reflects the current top marginal tax on capital gains in Nova Scotia, according to Ernst & Young.) On an after-tax basis, the market turned each dollar invested into $10.70, which is equivalent to an average annual growth rate of 6.6%.

But the misery doesn’t end there. Investors also have to factor inflation into the mix. (Inflation is the propensity for goods to become more expensive over time and it is often considered to be a form of taxation.) The inflation-adjusted after-tax rate of return falls to 3.4%, which turns a dollar’s worth of purchasing power into $3.46 over the period.

That’s a rough measure of where things stand today. But the situation would be much worse if the capital gains rate climbs from 27% to 54% as some have suggested it might. (That would be the same rate that’s currently charged on interest income in Nova Scotia.)

Apply a 54% tax on the market’s gains annually and each dollar invested grows to $4.62, which reflects an average annual return of 4.2% from 1980 through 2016. Add inflation into the mix and the dollar worth of purchasing power climbs to just $1.46, for an average annual real return of 1.0%.

That strikes me as a pretty paltry return for taking on all of the risk of the stock market over the course of almost four decades. Throw a 2% annual fund fee into the mix and the situation becomes grim indeed.

The heavy toll of taxation is a big reason why investors should try to boost their after-tax returns by using tax-favoured accounts like RRSPs and TFSAs in an efficient manner. They can also hold stocks for longer periods when investing money in taxable accounts to avoid triggering a tax bill each year.

But, with a little luck, the pundits will be proven to be wrong and savings won’t be taxed more onerously this year.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of February 13. The list is a good starting point for those who want to put some money to work this week.  Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.


Name Price P/B P/E Earnings Yield Dividend Yield
TELUS (T) $43.07 3.21 20.81 4.81% 4.46%
CIBC (CM) $115.47 2.04 10.77 9.28% 4.30%
Power (POW) $31.50 1.16 15.69 6.37% 4.25%
Shaw (SJR.B) $27.98 2.51 12.44 8.04% 4.24%
National Bank (NA) $57.77 2.03 17.45 5.73% 3.88%
Fortis (FTS) $42.68 1.51 22.7 4.40% 3.75%
Bank of Nova Scotia (BNS) $80.51 1.85 13.86 7.22% 3.68%
Bank of Montreal (BMO) $100.73 1.69 14.49 6.90% 3.49%
Royal Bank of Canada (RY) $97.12 2.24 14.28 7.00% 3.42%
Manulife (MFC) $24.59 1.27 17.44 5.73% 3.33%

Source: Bloomberg, February 13, 2017

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently.  Remember, stocks can be risky.  So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

 

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