Portfolio management
Biting the bullet
This post will be of interest to investors who are either retired or thinking about their retirement. Most countries tax regimes have two different kinds of investment account. The first is a normal taxable account and the second is a tax free or tax advantaged account.
Canada has a variety of tax advantaged accounts and no doubt the rules of the game are different in different countries. The tax advantaged accounts reflect public policy to encourage saving and investing for retirement. My wife and I each have three investment accounts, two of which are tax advantaged.
The tax advantaged account discussed in this post is one in which you get a tax deduction on contribution before retirement, enjoy tax free compounding until retirement and then pay tax at full marginal rate on all withdrawals (RRSP).
A big decision to make
When we retired 20 years ago, we moved to a stage in life where we were going to live from our investments, with no other income. We had a big decision to make. Should we draw money from our taxable accounts first or should we draw money from our tax advantaged accounts first, or some combination?
The conventional wisdom at the time was to draw from taxable accounts first. This first approach would allow the tax advantaged accounts to compound tax free until needed, subject to some minimum withdrawal rules after retirement. The other benefit would be that dividends when received and capital gains when cashed, in the taxable accounts, would be taxed at very favorable rates meaning that our after-tax returns would be tax advantaged over bond interest income.
The second approach would be to draw first from the tax advantaged accounts. These accounts had built tax free for over 30 years. Every contribution to the accounts over the years allowed a tax deduction against then current income. This treatment came with a downside. Every withdrawal from these accounts would be taxed at the then marginal rate.
Pro’s and con’s
On retirement, I had my accountant prepare a spread sheet to compare the two approaches. The upside, but really downside, to the first approach was that if the tax advantaged accounts were left to compound over say, 20 years of easy retirement, they would grow to a large dollar value. If by that time the taxable accounts were depleted, all money to live on would have to come from the tax advantaged accounts but be taxable at full marginal rate. As well, on death, the full capital amount of the tax advantaged accounts would be taxed at full top marginal rate. What bothered me about the first approach was that at the end of 20 years of easy retirement, all dividends and capital gains in the tax advantaged accounts that had accumulated would be taxed on withdrawal at our full marginal rate and not at the very favorable rates accorded to dividends and capital gains.
Companies that compound internally
Alongside that, I thought about the tax treatment of our taxable accounts. In Professor Lawrence A. Cunningham’s The Essays of Warren Buffett: Lessons for Corporate America published in 1998, (Buffett, W. E. 1998) there is a section titled Taxation and Investment Philosophy at p204. Everybody knows that Buffett’s favorite holding period is forever. There is a tax consequence to this. In the 1993 chairman’s letter Buffett tells an invented story about investing and the comic strip character Li’l Abner.
Buffett writes: “What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago.” (Buffett, W. E. 1998) p206
This thinking caused me to reflect on the tax treatment of our taxable accounts. Dividends are taxable as you go along, but in Canada at a rate about half of one’s marginal rate. Capital gains are taxable only when realized and then only at a very favorable rate. This meant that in retirement, the taxable account had to a large extent some of the same benefits as the tax advantaged account – tax free compounding.
One’s investment style
Hand in hand with these thoughts one must reflect on one’s investment style. I like to think that the following quote from Warren Buffett describes the kind of companies I like to invest in. In the 1992 Chairman’s letter he wrote: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., 1998) p86
This has meant that over the years the greater part of our investment returns has come from capital gains rather than from dividends.
Taxable vs tax advantaged accounts
My first thought about whether to live off money from taxable vs tax advantages accounts first was the thought that all our dividends and capital gains in the tax advantaged account would be taxable at our full marginal rate and this seemed bad. My second thought was that if we lived off our tax advantaged accounts until they were depleted our taxable accounts could accumulate capital gains tax free and only be taxed as and when we cashed them in and then only at a very favorable rate.
Other considerations
The basic financial rule in life is to live within your means. Another good rule is to bite the bullet first because everything that comes after will be easier. Wikipedia says “Biting the bullet” is a metaphor which is used to describe a situation, often a debate, where one accepts an inevitable impending hardship or hard-to-refute point, and then endures the resulting pain with fortitude.
The bullet for me when we first retired was to pay tax on all withdrawals from the tax advantaged accounts from the get go. This pain would be endured. But, once those accounts were depleted, our tax rate would be roughly halved for the same amount of money to live on because it would be from our taxable accounts – dividends and capital gains taxed at a very favorable rate.
The living within our means simply meant that over the years (on average) we would not deplete our investment savings below the total portfolio value that existed when we retired. Biting the bullet of paying full marginal rate on even capital gains meant that later I could take full advantage of the lower capital gains rate.
Bottom line
In simple terms this means that today, after being retired for 20 years, we have the opportunity of enjoying a much lower tax rate on the same average dollar amount of investment returns. When our investments are passed on to our children there will be no one-time full marginal rate tax to pay.
One aside
My wife and I also have tax advantaged accounts not part of this discussion. They were created by the Canadian gov’t within the last ten years. These accounts, simply called Tax Free Savings Accounts, do not give you a tax deduction with contributions and there is no tax on withdrawal. So, they are a nice vehicle to compound tax free. The other tax advantaged account discussed above allowed a tax deduction for contributions which was great for me while I was working and had a top marginal rate.
Conclusion
When we first retired, I fussed over the decision about which accounts, taxable or tax advantaged, to draw money from to live on. Today, after being retired for 20 years, I am satisfied I made the right decision to draw from the (RRSP) tax advantaged account first.
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