Want to earn $50,000, no tax? Stay with me.
I don’t know how many people buy real estate because they’re afraid of everything else, but it’s probably a big number. Since 2008 house prices have hit historic highs, along with mortgage debt and the home ownership ratio. It’s all related.
Same with GICs and high-interest savings accounts. Billions collect dust there because most folks are financially illiterate, or had the poop scared out of them. Or both.
Too bad. Ignorance and fear are infectious. Every time I mention the long-term historical average returns of balanced and diversified portfolios (around 7% over the last decade), I can count on incredulous comments like this:
I always chuckle at the 7% “well balanced portfolio” No risk, like picking up a block of cheese at the grocery store. Compete crap. Garth, how can you post day in day out this 7% growth and believe it? NOBODY get 7% annual return year in year out. NOBODY. — T
That’s quite right. No portfolio yields the same every twelve months. Last year, for example, a balanced portfolio (60% equity index, 40% bond index) delivered 9.3%. But the year before it was 0%. The year before that, about 8.5%. And so on. The ten-year average is just shy of 7%. If you’re saving for retirement, it strikes me that a good annualized return is more important than yearly swings. But then, I have confidence. T doesn’t. He sounds like a GIC guy, which means he collects 2% every 12 months, sees it dissolved by inflation and pays tax at the full marginal rate. No wonder he’s pissed.
Others come to this pathetic blog to blow over lower values in the last few months for real estate trusts or preferred shares, both of which hold minority positions in a balanced account. True enough – given the US Fed’s ambition to reduce its bond-buying program, bond yields have risen and income-generating assets have fallen. Now you can buy REITs and preferreds about 10% or 15% less than at their peak last spring.
But most people aren’t contrarian. They grab stuff at its zenith and come here to bitch when it’s on sale. So predictable. Just like houses. As prices rise, so do sales. Sigh.
Let’s talk about preferreds, and why you might want to own some. These assets are called ‘fixed-income’ because that’s what they do – pay you to own them. They’re not purchased for the same reason common stocks are owned, which is for a capital gain. In fact, preferred shares (in big, profitable companies like banks) are notoriously stable in their pricing, reacting to moves in interest rates, not profits of the issuing corporation. Buy the right ones, and they pay a fixed dividend while also having a par value (like a bond) at which they will be redeemed, often giving you a gain as well as income.
Today, thanks to recent dips (temporary, it seems) in fixed-income prices, bank preferreds are churning out more than 5% in dividend income, which also allows you to collect the dividend tax credit. For higher-income investors that boosts the effective yield closer to 7%. In fact, if you owned only preferreds, or other assets paying dividends, you could create a $50,000 annual income stream and pay no tax at all. Ziltch.
This is thanks to the basic personal credit plus the tax treatment of dividend income. In case you don’t realize it, the money you earn going to work, collect in GIC interest or as rent from income property is taxed at the highest rate. Profits made from capital gains when you sell a stock or ETF for more than you paid, are 50% tax-free. And dividend income comes with that fat tax credit that cuts tax in half or can even wipe it out.
Why? Because dividends are paid to you by companies from their after-tax income. It wouldn’t be fair to tax it fully again in your hands. So on your tax return you gross-up dividend income then deduct the credit – and it’s all good.
For example if you owned a million in bank preferreds (hardly balanced, but illustrative) the roughly $50,000 income paid to you annually would attract about $16,000 in tax, all of which is wiped out by the basic personal credit plus the dividend tax credit. You get to keep it all. Sweet.
This is why people buy things like preferreds shares and real estate investment trusts – distributions which currently range from 4% to 7% from assets whose returns are fixed, or based on the strong cash flow of underlying assets. So, what happens when interest rates creep higher and the capital values of these things erodes, as has happened over the last four months?
In practical terms, nothing. You still receive your income. You collect the tax credits. Your income’s not affected. And if you don’t plan on cashing in your investments when they are 10% lower, then you lose nothing – which is exactly the point of having a fixed-income stream of cash. Interest rates have shot up dramatically since May, a situation likely to reverse a little, since the bond market flipped out. Meanwhile demand for preferreds remains very strong, for obvious reasons – a factor mitigating the gradual ascent of rates over coming years.
Of course, that same movement will be devastating to those who bought houses with lots of leverage.
What a surprise that will be.