Don’t Overlook the Impact of Taxes & Inflation on Investment Returns

As a reminder, when we think about our investments, consider the impact of taxes on returns. And, as inflation continues to be at above-average levels, we should also not overlook its effect on returns.

Consider the way that different types of investments in non-registered accounts are taxed. Interest income from fixed-income investments like guaranteed investment certificates or treasury bills is taxed at an investor’s highest marginal tax rate, similar to regular income. Equities receive the most favourable tax treatment because only 50 percent of the capital gain is subject to income tax. Dividend income is generally taxed at a lower rate than interest income because of the dividend tax credit that applies to most dividends received from eligible Canadian corporations.

Inflation can also erode an investment’s returns as it reduces purchasing power over time. Today, as interest rates have risen to levels not seen in decades, there may be excitement at the prospect of achieving a four percent rate of return on low-risk, fixed-income investments like guaranteed investment certificates (GICs). While the “nominal” return — before inflation — may be around 4 percent, with inflation hovering around 6 percent today, the “real” return ends up being negative, at around -2 percent, and this is even before considering taxes. Today, savers can’t even keep up with declining purchasing power. Of course, historically, interest rates have generally been higher than the inflation rate, which makes today’s situation unique. And, inflation isn’t expected to remain at these elevated levels; it continues to show signs of moderating. Since 1990, the longer-term average inflation rate — and the target of the central banks — has been closer to 2 percent. The chart (right) shows the potential effect of both taxes and inflation on varying investment returns in a non-registered account based on longer-term averages (illustrative).
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The bottom line? As investors, we need to ensure that our assets can grow enough to offset the potential effects of inflation. History has shown that being invested in equities over the longer term has been a good way to stay ahead of inflation. We also should not overlook the impact that taxes can have on our investment returns, using tax-advantaged accounts, such as the RRSP and TFSA to our benefit. The opportunity to allow investments to grow over time while being sheltered from taxes has never been more important.

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