Retirement Income Investing: The Dreaded RMD

All of us are approaching retirement, many of us are already there, and some of us (myself included) are thinking about the ultimate IRS slap-in-the-face… The Required Minimum Distribution. It’s time to make sure that your retirement income program is actually ready.

Every investment program becomes a retirement income program eventually.

First off, you need to get to a place where you can say:

“a stock market downturn will have no significant impact on my retirement income”

This applies to everyone; income development is always important, and Tax Free Income (outside the IRA or 401k) is The Very Best. Only private “safe haven” 401k plans are capable of focusing on income development.

Retirement readiness requires active consideration of your asset allocation, your overall diversification, and most importantly, the quality of your holdings. Those of you who are relying on 401k assets to fund your retirement income requirements need to look inside the program.

If you are within five years of retirement, repositioning at the top of a stock market cycle (now) is essential; if you are in retirement, get your portfolio out of any employer plans and into your IRA… you just can’t protect yourself  (and especially, your income) in Mutual Funds or ETFs.

If you are approaching 70, the RMD is “in your face”… here’s how to handle it:

• Position the portfolio to produce slightly more income than you must take from the program.

• Take the income monthly and DO NOT pay the taxes in advance. Lump sum withdrawals require uninvested cash reserves and/or untimely sell transactions.

• Move the RMD disbursements into an individual or joint account and reinvest at least 30% in Tax Free Income CEFs.

• If you hold equities (in addition to the RMD income producers you need), set your profit taking targets lower than usual… and maintain the Cost Based Asset Allocation.

I’m relatively sure that some of you are currently dealing with the RMD incorrectly… with “lump sum + the taxes” distributions.

Some of you have been to my ongoing series of “live SRS portfolio review, Income Investing Webinars”.

Follow this link to the recording of the January 22nd private presentation and don’t hesitate to post it where ever you like… wouldn’t it be cool to have this presentation show up on YouTube.

https://www.dropbox.com/s/28ty6z5dkgn5ulu/Retirement%20Income%20Webinar.wmv?dl=0

The Microsoft Retirement Income Program

Reading Between the Lines

Once we recognize that all investment portfolios eventually become retirement income portfolios, we can begin to focus on the regular recurring income that they produce… retired or not, the market value of your private portfolio (or of your 401k plan) has no purchasing power.

Yet all 401k programs are performance evaluated on market value growth as opposed to income production.

In late 1999, Microsoft Corporation (MSFT) common stock was at an all time high of $58.38 (split adjusted), and there were thousands of MSFT multi-millionaires out there confident that their retirement was secure…. with a guaranteed monthly income of ?

Please send me an email with the amount of income produced by a million dollars worth of Microsoft in 1999… or your favorite ETF or TDF today.

Several years later, one of those millionaires, and a golf buddy of mine, disclosed that he had just sold the 7 series BMW he had purchased with the proceeds of his MSFT stock… the one “asset” he still had from his dot.com fortune. Pushing 65, he just couldn’t bear the memory any longer.

If only he had sold the entire portfolio… or converted enough to tax free Closed End Funds to assure a lifetime income.

Yet no 401k programs today will hold income Closed End Funds (yielding 7% or so right now). Why? Because, according to the Department of Labor, 2% after low expenses is better than 7% after higher expenses.

By September 2000, MSFT stock had fallen by almost 50%; nearly 15 years later, with the market near its highest numberl ever, MSFT (at $47.60) remains 18% below its 1999 level… it didn’t pay a dividend until 2003, and its dividend yield today is only 2.6%, after many increases.

Back then, most Mutual Fund portfolios contained MSFT and hundreds of similar NASDAQ securities…  and this was OK with all varieties of regulators and plan fiduciaries because the markets, after all, were trending upward.

MCIM portfolios contained no NASDAQ equities, no Mutual Funds at all, and a growing income component of at least 30%… hmmm.

It took more than 15 years for NASDAQ to regain its 1999 level… how many of the heroes survived?

Today, most Mutual Fund investment portfolios and ETF gaming devices contain 1999 Microsoft look alikes, and most pay very little income…

MCIM portfolios? Well, no… no Mutual Funds, and no ETFs, just IGVSI (NYSE dividend paying) equities, and an income CEF component of at least 40%.

Can you get an MCIM Income Purpose portfolio in your IRA… absolutely;  in your 401k…  it’s a long sad story.

What’s in your wallet?

Retirement Income Webinar Sign-Up

Lower gas prices can mean really big TFSA savings!

Many Canadians have grown accustomed to low mortgage rates and strong residential pricing, and now the price of gasoline is leaving a few more bucks in our pockets.  Don’t get too comfortable, because history teaches us that none of this is sustainable.  It is circumstances like the present that make seasoned money managers anxious.  While neophytes are happy to carelessly bathe in the sunshine, experts are usually getting ready for the next storm.  What can you do?  With lower gasoline prices providing some extra cash flow why not use the cash to bolster your savings?

One cloud on the horizon has been getting some attention of late.  The massive global financial stimulus that has caused interest rates to remain low for so long has had a predictable impact on our collective behaviour.  Canadians have borrowed money like there’s no tomorrow.

Household Debt vs Disponable IncomeAccording to data from Statistics Canada, our total borrowing has been on a steady incline since 1990, while servicing the debt has been eating away at our disposable income.  Sure, we tightened our belts some during the financial crisis, but the temptation to borrow at low rates has just been too much to overcome.

It is difficult to save money, when so little of one’s income is disposable.  And most financial advisers would recommend that it doesn’t make a whole bunch of sense to save money at all when you owe money.  It makes far more financial sense to pay down your debt.  Based on numbers alone, this is sound advice.  But our behaviour is seldom governed by numbers alone – we are indeed a complex species.

For example, contributing to your RRSP provides a tax savings in the same year your contribute right?  So where does it go?  A strictly numbers analysis espousing the merits of RRSPs would certainly factor in those savings to illustrate how effective they are at growing your wealth, but I am inclined to agree with the Wealthy Barber (David Chilton) who frequently points out (and I am paraphrasing here) that those dollars you supposedly ‘saved’ were most probably squandered, not saved.  If the tax savings were indeed invested, then it is true that one’s net worth might grow.  However the iPhone, piece of furniture or other consumer good bought with that tax refund hardly qualifies as savings now does it?

Does it make any sense at all to save when wallowing in debt?  I would argue most emphatically YES!  According to an IPSOS Reid poll published in October:  “The average working Canadian believes they would need $45,609 in savings to sustain themselves for a year should they be off work due to illness.”  Where would this money come from?  In real life, a portion of it would be required for food and lodging yet some of it will be needed just to pay the mortgage or rent.  I’d bet that the average Canadian polled would no doubt have seriously underestimated the amount needed to live on while not working (for whatever reason).  In the same poll roughly 68% admitted to having some or lots of debt – suggesting that 1/3rd of Canadians have none?  Pardon me if I suspect that a good percentage of those polled might also have been too embarrassed to answer candidly even if their responses remained anonymous – we are Canadians after all and loathe to taint our conservative image.

Now is an ideal time to bump up your savings!

Where will the extra cash come from to begin a more aggressive savings program?  Let’s start at the gas pump.  We all feel a bit of relief simply watching the price of gasoline come down when fueling, but has anyone really considered how much they might now be pocketing because of lower energy prices?  In April of 2014 Canadians were paying a near-record $1.50 per litre.  Just 6 months ago the price of gasoline in Toronto was 139.9 cents a litre and today (I am writing this on December 10) it is 103.9 cents.  That’s a whopping 25% decrease.  Say a motorist was spending $50 in after-tax dollars a week.  If they price of gas simply stays at 103.9 the cost savings are $12.50 a week which is equivalent to $650 of annual savings requiring about $1000 of your pre-tax income.  If there is more than one vehicle in a family? Let’s keep it simple and assume $1000 in annual family savings simply from the lower gasoline price.  Never mind that other energy costs (heating) and transportation costs (flights) will also create savings.  What if you simply invested that amount every year and earned a rate of return on it?  It will grow to a handsome sum.  Unfortunately, you will have to pay taxes on those returns but more about that later.

Growth in $1000 annually

 

Of course it’s unreasonable to expect gas prices to remain at these levels or fall lower.  It is also not wise to anticipate more generous rates of return.  In point of fact, it is foolhardy to expect or anticipate anything at all.  Returns will be what they will be, and gas prices are determined by market forces that the experts have trouble understanding.

Does the uncertainty we must live with mean that savings might just as well be spent on the fly?  As I tell students studying to be financial planners; one must start somewhere and there are two things worth acknowledging up front:

1)  The power of compounding (letting money earn money by investing it) is very real, as evidenced by the table.

2)  It makes sense to have a cushion in the event of a loss of income, the desire to pay down some debt, make a purchase or just retire.

Yes it makes more financial sense to have no debt at all, but the majority of Canadians will borrow for those things they want now rather than later, like a home or car.  If you must borrow, why not save as well?  Fortunately we have been gifted the perfect savings vehicle.  The Tax Free Savings Account introduced in 2009 has advantages that make it an ideal place to park money you are saving at the gas pump.  The returns you earn in the account are tax-free.  With GIC rates as low as they are, you might be inclined to say ‘so big deal?’ But any financial adviser over 45 years of age (I admit, there aren’t many) can tell you that low interest rates are temporary, and besides you can and will earn better returns over the longer term in equity mutual funds just as an example.

TFSA Contribution LimitsOf course there are limits (see table) to what you are allowed to contribute, but best of all they are cumulative.  In other words, if you haven’t contributed your limit since 2009, you can ‘catch up’ at any time.  Including 2014, you have a right to have put up to $31,000 into the account.   Also the contribution limit rises (is indexed) over time with the rate of inflation.  Perhaps most important, you can withdraw money from the account tax-free.  Your contributions were already taxed (there’s no tax deduction when contributing like when you put funds into an RRSP), and the investment returns are all yours to keep.  Using your TFSA means that won’t have to pay those taxes and the effects of compounding aren’t diminished.  To top it off, you are allowed to replace any money you’ve withdrawn in following years.

The seasoned money manager will want some flexibility in the event that he is blindsided.  With your TFSA savings you too will enjoy more flexibility.  If interest rates are higher when you renegotiate your mortgage, taking money out of your TFSA to reduce the principal amount might help reduce your monthly payments to affordable levels.  Should the economy take a turn for the worse over the next several years and you lose your job, then you’ll have some extra cash available to retire debt and help with living expenses.  For younger Canadians saving money at the gas pump? Investing the extra cash flow in your TFSA account will certainly help towards building a healthy deposit for your first home.

  • Don’t squander the cash you are saving thanks to low energy prices.
  • Your TSFA if you have one, allows you to invest those savings and the returns you earn are tax free.
  • If you don’t have a TFSA, then get one.
  • Be sure to use only qualified investments and do not over-contribute. The penalties are severe.
  • Money earned on your investments is tax-free.
  • Take out cash when you need it, and put it back when you can.
  • When you retire, money withdrawn from your TFSA does not count as taxable income.

 

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

 

 

 

 

 

 

 

 

 

 

 

 

 

The S&P 500: 15 Years to Nowhere!

On November 30 1999, the S & P 500 Index was around 1,400, basking in the sunlight of what many analysts were calling the “No Value At All” or “Dot Com” Bubble. Roughly ten years later, December 31 2009, the Index was about 20% lower (@ 1,120) a mere ten months off a second major hit, the “Financial Crisis” bottom.

Most investors are intimately aware of these numbers, they lived through both major meltdowns and possibly a third way back in  October 1987… but they seem generally unfamiliar with S&P performance “backtesting” of companies it ranks “highest in fundamental quality” vs. the Index itself.

S&P backtesting shows that the higher quality companies have: less risk, lower debt levels, higher profit margins, and higher return on equity. They are also less likely to engage in accounting manipulations. AND, the highest quality ranked companies (B+ through A+) outperform the S&P Index itself. (research by K Gillogly, 2005)

What makes this especially interesting is the fact that the S&P 500 is representative of all sectors now mirrored by MPT birthed ETFs and conventional Mutual Funds… both of these investment (speculation?) vehicles ignore the S & P conclusions as they seem to make a concerted effort to avoid higher quality/lower risk possibilities… incom? What income.

In June 2005, S & P ranked just 1,100 companies “average” or above; less than half (518) were “above average”.

The November 1999 through December 2009 investment climate (the media dubbed “Dismal Decade”) was not so dismal at all, for investors who used S&P quality rankings in their equity investment strategy. In looking at this time frame, and studying investment portfolios containing only S&P B+ and higher ranked companies in their equity asset allocation, researches found an alternative investment performance universe.

The portfolios contained a “refined” collection of companies, tracked since 2007 as “The Investment Grade Value Stock Index” (IGVSI). In addition to the B+ or better S&P ranking, these companies were NYSE only, and dividend paying… fewer than 500 companies ever qualified, and portfolio management used several other risk minimizers in an active trading environment…

For “quality” comparison purposes, mutual funds contained in the most conservative of Target Return Funds now contain over 5,000 individual equities!

Additionally, the 55 separately managed portfolios in the study had an overall asset allocation of roughly 60% equity and 40% income purpose securities… and all asset allocation/diversification decisions were made using a “cost based” methodology called “The Working Capital Model”.

So for the ten years studied by the original researcher and two other entities, while the passive S & P 500 slid 20%, these actively managed portfolios grew between 18% and 253%… an average 72.5%, while NASDAQ fell 32% and the “Blue Chip” DJIA fell 4.5%.

So for analysis sake, lets superimpose the more recent 5 years of annual market value growth of the Investment Grade Value Stock Index and the S&P 500 on top of the performance of hypothetical $100,000 portfolios since November 30th 1999.

The S&P Portfolio fell to $80,000 from November ’99 through December 2009. Since then, it’s 69.2% gain produces a right now portfolio value of $135,392… a gain of roughly 2.36% per year. On the income side, the portfolio would have produced roughly 2% spending money per year.

The 60% IGVSI Equity + 40% income purpose securities portfolios rose to $172,500 through December 2009. The past 5 years have pushed the portfolio totals to roughly $271,843 while producing an income only cash flow in the 7% neighborhood.

So this hypothetical combination of supported research and educated estimation produce a quality equity +  40% income purpose based portfolio growth rate roughly five times the rate of the equity only S&P 500 Index… and this without even considering the compounding effect of higher income and 15 years worth of profit taking.

Yet in spite of all this evidence, 401k participants are not allowed access to such old fashioned programs… the “catch 22” of the “why” will amaze you. Plan investment policy statements preclude investments that have a limited track record, and or a small amount under management….

The program described above has been around longer than any ETF anywhere, longer than most of the Mutual Funds in the 401k space, and has been managed longer by the same person, in the same format, than (just guessing with 44 years of operation), than any other out there. Yet, a new package makes the product unacceptable….

As you think about the recent carnage in your 401k account balances (even if it proves to be temporary), shouldn’t you, your employer, your plan advisor, your plan fiduciary, have had the chance to say: “hey, high-quality dividend paying companies and 40% or more invested to grow my retirement income… makes sense to me!”

 

DATELINE: New York Stock Exchange, Valentine’s Day, 2015

Alternative A: Valentine’s Day Massacre Highlights Frenzied Five Month Downturn!

Alternative B: Valentine’s Day Champagne Toasts Spectacular Six Year Rally!

No matter which of these scenarios plays out, your primary concern should be preparedness… a case could certainly be made for either. Market Cycle Investment Management (MCIM) investors have little reason to worry.

Equity Portfolios are lean and mean, augmented in recent months by a selection of “defensive” issues whose higher yield and business models make them less likely to erode as seriously as overpriced, lower yielding derivatives.

As usual, absolutely no reasonable profit has been allowed to go unrealized, and several non-performers have been removed from portfolios. Equity Bucket cash positions are abnormally high as a result of profit taking and a shorter than normal “buy list”.

Income levels in all portfolios are at an historical high for two reasons: the Equity Bucket REIT (Real Estate Investment Trust) and MLP (Master Limited Partnership) additions mentioned above and the continued cash flow dependability of both Income and Equity Closed End Funds.

The fact that income purpose securities are at lower market valuations (while generating about the same level of income) is an excellent income investing opportunity, but you need to add to your holdings to take advantage of it.

If you have a 5 year or less retirement window, it’s time to make some decisions.

If there is any portfolio where you have not harvested at least some of your profits (particularly in your 401ks and other self-directed retirement vehicles), why not do so while you can still obtain Tax Free 6% and Taxable 7.5% CEFs?

If you have been holding money in low yield guaranteed vehicles, it’s time to smell the roses… you’ve seen your CEFs pay their normal distributions, month after month after month… regardless of market conditions.

Talk to your 401k advisor and insist upon higher yielding, Collective Trust income options.

So which of the headliner scenarios is more likely? and should you really care?

No one really knows when the correction will begin, but everyone agrees that it will… eventually, and stealthily. And no, it shouldn’t really upset an MCIM user’s plans significantly.

Whenever the correction happens, your income purpose securities are likely to fall much less than in the financial crisis. Your equity positions (Investment Grade Value Stocks, REITS, and MLPs) historically do not fall as far as stocks of lesser quality… during the dot-com fiasco, they didn’t fall at all.

…and, after both the October ’87 “crash” and the more recent financial crisis, IGVSI stocks rebounded to new highs years before the S & P 500.

Of this I am certain, your 401k is not ready.

Is the General Practitioner a dying breed of Financial Advisor?

In my last blog, I introduced the concept of “strike teams” as a potential solution to the solo advisor trying to be “all things to all eople at all times” – which is, of course, an impossibility.

So what is a “strike team”? STs are groups of advisors – each with their own specialty or specialties – that work together as a team with EVERY client they each bring to the table. Clients and prospects are introduced to the entire team and the engagement is for the entire team. In the ideal world, this team would include specific formal business arrangements with an accredited mortgage broker, a business and personal banker, one or more CAs or CGAs and lawyers (or law firms) that cover all needed areas of professional practice.

I believe that both eisting clients and prospective clients have the right to expect full service from their advisors with the exception of those advisors who choose to hold themselves out as specialists in only 1 area of practice – and the clients know this and understand they have to go elsewhere for the balance of their financial needs. I believe advisors do a dis-service to themselves, their clients and the industry when they try to convince everyone they can do it all – it just isn’t possible, so why pretend?

I don’t see this as a need for every advisor to run around and find like-minded colleagues with whom they can immediately form this type of team. However, I firmly believe this is the way forward for advisors who wish to be at the leading edge of this profession. In closing, I am reminded of a statement I heard about the difference between generalists and specialists (from a few decades back I am afraid but it is even more true today):

A generalist learns less and less about more and more until they know nothing about everything while a specialist learns more and more about less and less until they know everything about nothing.

Can a single advisor handle it all?

So far in 2013, there has been a lot of discussion about the potential for “one-stop-shopping” either through advisors or through certain financial institutions. This begs a basic question in my mind – can any one advisor or any one FI properly handle all of the financial matters for a client?

From the perspective of the FIs, they would like the public to believe that they can, in fact, handle everything through in-house advisors or a team of advisors. Does this claim stand-up in the cold light of day? I suggest not. Financial planning, in all of it’s complexities and forms, is based on a close personal relationship between the client and the advisor(s) involved. FIs suffer from a few issues in this regard including lack of continuity, perceptions of conflicts of interest in products and services recommended – predominantly in-house or house-labelled generic products – lack of objectivity also springs to mind.

So what about the individual advisor? Currently we have two versions of this creature on the loose – the independent group (the largest in numbers) and the closely-tied (or career) advisors that represent one company (maybe with one or two strategic alliances to flesh-out their potential offering). I will offer some comments on the latter here. Everyone knows that no one company – regardless of size and breadth of offering – can be all things to all people at all times. Assuming that you accept this premise, the ability of the closely-tied advisor to hande all matters is obviously seriously impaired as is their ability to claim to offer independent and objective advice on all matters financial.

So what about the independent advisor? Can they fill these gaps? Again, I have to say no. While the vast majority of these advisors seem to stress their ability and talents in this area, at best they make broad-brush attempts – albeit very well meaning – but still fundamentally lack the knowledge and full product and service suite.

Is there a solution? I believe the answer here is YES. I believe the answer is what I call “strike teams”. Stay tuned for my next blog where is hare this concept in more detail! Cheers

Canada’s most flexible and legitimate tax shelter!

In 2004 I wrote a book (with my friend Pamela Clarke and published by Insomniac Press) called Resources Rock: How to Invest and Profit from the Next Global Boom in Natural Resources. Since taxes are fresh in everyone’s mind at this time of year, I thought I’d reproduce a chapter in the book that explains one of Canada’s most flexible and robust tax planning tools. It’s not widely understood but has the advantage of being 100% legitimate – it is written right in our tax code. Here’s the chapter:

“Certainty? In this world, nothing is certain but death and taxes,” said American scientist Benjamin Franklin over two hundred years ago. The only difference these days is that while death is still final, taxes can be deferred or reduced. Canadians didn’t always have to worry about taxes. Income tax was introduced as a temporary measure (sounds like the GST saga) to help cover the country’s military expenses during World War I. By 1948, the wars were over, but the government decided to not surrender. Instead, the Income War Tax Act became the Income Tax Act. Since then, Canadians have had to declare income from all sources, including capital gains on the sale of investments or property. We’re allowed to deduct some expenses and there are a few tax credits, but by and large, there aren’t too many opportunities for us to reduce our taxable income. Taxes are steep and vary greatly depending on where you live.

But that’s not all. You pay tax on everything you earn as well as on everything you buy. Take the price of gas, for example. It was pumped up to over $1.40 a liter in some provinces and more than one-third of the price was taxes: provincial sales tax, GST, and something called the Federal Excise Tax. It hurts even more if you consider that you’re paying for the gas taxes with after-tax dollars. Ouch.

One of the best means of minimizing the pain is to take advantage of all the tax deductions that you can. Standard ones include childcare expenses, family support payments, moving and medical costs, and of course, RRSP contributions. Unfortunately, not too many taxpayers are familiar with the deductions that are available from investing in the “flow-through” shares of junior Canadian resource companies, or ventures that qualify for the Canadian Exploration Expense (CEE). You should consult your tax advisor for precise information on the benefits of these deductions for your portfolio, but in the meantime, here’s a brief introduction to these tax-deductible investments.

Buried deep in the Income Tax Act (Section 66 (1) to be exact) there’s a clause that says:

“A principal-business corporation may deduct, in computing its income for a taxation year, the lesser of (a) the total of such of its Canadian exploration and development expenses as were incurred by it before the end of the taxation year…”

The Section goes on ad nauseam, but only tax accountants need to get into that level of detail. What you do need to know from the clause is that most junior energy and mining companies spend all of their money on exploration programs and usually have little or no revenue. Because they have virtually zero income, they’re not able to use all the tax deductions that they’re entitled to as a resource exploration company. Mining companies are allowed to deduct prospecting, drilling, geological or geophysical expenses, but if they don’t have any revenue, then these deductions remain unclaimed or“wasted”.

In a rare moment of generosity, the government decided to allow exploration companies to give up those tax deductions and pass them on to people who can use them. Companies can bundle the tax deductions with their shares, then sell them to investors and use the proceeds from the sale of these shares to finance their exploration projects. The ventures don’t mind selling off their unused deductions. If they can’t afford to keep digging or drilling, they’ll be out of business anyway. These deductions, sold as shares, are called “flow-through shares” because they transfer the tax deductions from the company to the investor.

In other words, the government allows a tax deduction that would usually only be granted to an exploration venture to be passed on, or “flow-through,” to their investors. It’s a win-win situation as the company gets the money to finance their exploration work while investors can claim up to 100% of their investment as a tax deduction. The government created this program as a means of encouraging people to invest in resource exploration companies. That’s nice of them, but given our incredibly high tax rates, it’s a good idea to understand how investing in exploration—either in flow-through shares, or in shares of a limited partnership that owns a portfolio of flow-through shares—can help you lower your taxable income.

Investors can buy flow-through shares directly from a company, or own them indirectly by purchasing units in a limited partnership specially created to buy shares in a portfolio of several junior exploration companies. Buying units in a limited partnership can be beneficial for individual investors because it gives them the tax deduction from the flow-through shares, in addition to reducing their investment risk. A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor could afford to purchase on their own. Therefore, investors in a limited partnership end up owning shares in a basket of startups, rather than just in one venture. Given that a lot of exploration companies could go bankrupt or walk away from their projects, buying shares in several of them minimizes the risk that you could lose your entire investment. The answer varies from one investor to another, but as long as the exploration company – or companies if they’re in a portfolio owned by a limited partnership – spends all the money they raised from selling flow-through shares on eligible exploration expenses, then almost the entire amount invested in the shares can be deducted.

A word of caution: Don’t let the tax appeal of flow-through shares affect your decision-making skills as an investor. Remember that even though the tax deductions alone are beneficial, you’re still investing in the riskiest side of the resource industry. It is possible for you to lose all your money if the exploration team repeatedly comes up empty-handed. On the other hand, investing in an exploration startup by means of flow-through shares does mitigate the risk of losing your investment to some extent. Depending on your marginal tax rate, the after-tax cost of buying the flow-through shares (or portfolio of flow-through shares) is virtually cut in half, compliments of the government .

In the Economic Statement and Budget Update of October 18, 2000, the Minister of Finance announced a temporary, 15% investment tax credit (applied to eligible exploration expenses) for investors in flow-through shares of mineral exploration companies. Oil and gas exploration companies were excluded. This announcement introduced a credit, known officially as the Investment Tax Credit for Exploration(ITCE), which reduces an investor’s federal income tax for the taxation year during which the investment is made. Although deemed ‘temporary’, after expiring at the end of 2005, the credit was re-introduced effective May 2,2006 and is currently subject to annual review.

The ITCE is a non-refundable tax credit that can be carried back three years or carried forward twenty years. So if you invest in flow-through shares (of mining exploration companies only) this year, you can use the deduction any time up to 20 years in the future, or back three years. It’s a real bonus being able to use this deduction when you need it the most. Keep in mind, however, that the ITCE has to be reported as income in the year after you claimed the tax deductions from the flow-through shares. The only downside is that when you sell your investment, or trigger a “deemed disposition”(which means the government thinks you’ve unloaded the investment even if you haven’t actually sold it), then you’re on the hook for capital gains tax. That’s not so bad, as capital gains tax rates are better than regular income tax rates.

Let’s look at how these tax credit programs can help you reduce your taxes. For example, if you live in Ontario and your annual taxable income is $300,000, and you’re taxed at the highest marginal tax rate of 46.41%, then you’d pay $139,230 in tax. (Of course, to make it simple,we’re unrealistically assuming there are no personal exemptions or other allowable deductions and that all income is taxed at the same rate.) If you invested $50,000 in flow-through shares, and the entire amount qualified as a CEE, then 100% of your investment could be deducted from your taxable income. Your taxable income is reduced to $250,000 and you now owe $116,025 in taxes—a savings of $23,205! That’s a nice chunk of change that stays in your pocket.

It can get even better. If a part of your investment in flow-through shares is with companies that are exploring for metals and minerals that are eligible for the Federal Investment Tax Credit, you’ll get an additional tax credit of $7,500. That extra credit would cut your total tax bill down to $108,525. In a perfect world, you could save yourself $30,705 in taxes. Serious money by any standards.

In addition to these federal government programs, there are several provincial flow-through initiatives that we won’t address here as they vary tremendously from one province to another. Flow-through shares are starting to sound like they’re the best discovery since Chuck Fipke dug up some diamonds in the Northwest Territories. As wonderful as they are, keep in mind that since money is made and taxes are paid in the real world, things aren’t always as rosy as simplified examples in a book on investing. Before buying into the example above, remember that:

  • Taxes Vary: Everyone pays taxes on a sliding scale, so not all of your income is taxed at the top marginal rate.
  • Diversify: Your entire portfolio should never be solely invested in just mineral exploration stocks—diversification is advisable even for investors with an incredibly high tolerance for risk.
  • No Guarantees: An exploration company is obligated to spend 100% of the money it receives from selling flow-through shares on expenditures that qualify for tax deductions, but if for some reason it doesn’t, then you can’t claim 100% of the deductions.

The bottom line is that there are many variables that will influence the impact of flow-through shares on your tax situation. Investment advisors can provide details on the limited partnerships or flow-through shares that are available in the market today. Ask them to help you research and screen limited partnership funds so you end up investing in a portfolio of companies that meets your investment objectives.

That’s the end of the chapter, and before you say this is more complicated than it’s worth let me excessively simplify and round in order to provide an example of how powerful this tool can be.

Imagine you’ve sold an income property for $500,000 and long ago used up your personal capital gains exemption. To keep it simple, you are not subject to minimal tax and are at the highest marginal tax bracket which I will round to 50%. Let’s ignore all the other deductions and stuff too. Your options are:

1. Report the proceeds as income and let the CRA (government) keep half of your money.

2. Invest the entire sum in one (or more) flow-through limited partnerships.

Let’s examine #2. The $500,000 can now be deducted against income, so your taxable income (money going to CRA) is reduced – you keep half at 50% tax rate or (roughly) $250,000. So far you’re no worse off right? Even if your get nothing back (I’ve never seen this happen personally and I’ve managed dozens of these funds myself) you’re no worse off.

Say after two years (the lifespan of most of these funds) you get your whole investment back (it happens). Once the fund is wound up your $500,000 is now subject to capital gains tax (roughly 25% rather than 50%) so you’ll net $375,000. Isn’t keeping the extra $125,000 for yourself worth the effort? Whether you end up with half that amount, or double you are still ahead.

By the way, when a flow-through limited partnership is ‘wound up’ your money is usually rolled into a more liquid mutual fund – you can leave some or all the the money in there and not pay the capital gains taxes until you redeem. If you can afford it, use the tax shelter every year and watch your tax savings grow over time. You will have to pay a tax accountant (since filling out the tax returns correctly is critical and often you have to re-submit them when you receive additional or more precise information from the fund company after-the-fact), and seek advice from a good investment advisor. If either of them tells you not to do it without a really good explanation….it’s because they don’t understand them or want to avoid the added work. Find someone else.

Mal Spooner

 

You are energy efficient!

If you listen to extreme environmentalists, you’d think the entire human race was oblivious to the fact that many of the resources we use are non-renewable, and that our fate is to irresponsibly destroy the planet.

Well I have some good news. According to the U.S. Energy Information Adminstration’s (EIA) most recent Residential Energy Consumption Survey (RECS), U.S. homes built in 2000 and later consume only 2% more energy on average than homes built prior to 2000, despite being on average 30% larger.

I recall the brouhaha created when in 1972 (yes, I’m that old) when the Club of Rome (a distinguished think-tank) published a study called Limits to Growth. Many folks have since criticized the work, and still others have tried to defend it (by re-interpreting the study “using modern language” or some other sleight of hand). The prediction was that humanity’s pursuit of constant growth and consumption of resources (energy, food, trees etc.) would use up the planet within 100 years. Yes, Limits to Growth did suggest that if mankind undertook to minimize greed, control population growth and take advantage of technology that things might not turn out so bad, but it was unequivocally pessimistic about this possibility. Quite a stir was caused by the publication.

We had another panic more recently: The Association for the Study of Peak Oil and Gas (ASPO) suggested regular conventional oil reached an all time peak in 2005. The ‘theory’ was that we’ve used up half of the oil the earth has to offer, and so it’s all downhill from now on.

So how can it be that suddenly the U.S. is expected to be almost energy self-sufficient?

“The United States, which currently imports around 20 per cent of its total energy needs, becomes all but self-sufficient in net terms — a dramatic reversal of the trend seen in most other energy-importing countries,” the Paris-based International Energy Agency said in its World Energy Outlook released Monday Nov. 12, 2012.

What these ‘studies’ and occasional panics fail to take into account is the greatest innovation ever – CAPITALISM! Shortages and surpluses are corrected by economics. The laws of supply and demand and the unencumbered adjustments in pricing ensure that there are very few limits to growth. We’ve come to appreciate over the years that a ‘price’ isn’t necessarily a dollar amount. Increasingly some things are just too expensive if they also cause irreparable harm to the environment. When one non-renewable resources becomes just too expensive, we find substitutes (biofuel, gas, nuclear, clean coal and hydroelectric).

I’ve read that recent polls show falling support for capitalism all over the world. This is sad when you consider the alternatives. Was it better when no system existed? I visited Africa several years ago and learned that some areas had long ago been cleared of all indigenous tree varieties. In a primitive society everything belongs to everyone, and everyone managed to destroy every tree. A quick study of the former Soviet Union should make it clear that communism inflicted serious environmental damage and scarcity. The population of China only stopped starving once a more capitalist system was tolerated.

So fret not my friends. You are energy efficient, and no doubt one day your home will consume no fossil fuels at all. You will no doubt substitute an electric vehicle for your hybrid. Personally, I pray there will be enough oil and gasoline left, no matter how expensive, so that I can still ride my Harley-Davidson motorcycle.

 

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And a Happy New Year to all!

, T-bnAs we finally close 2012, there are many things on which we can reflect. The sad, the inexplicable, the disappointing and yes, some good things too – from an investment perspective anyway!

Canadian banks and other financial institutions, despite a credit downgrade late in the year, are among the safest in the world and investors continue to benefit from holding their preferred shares, common stocks and various debt instruments. The same appears true for the utility industry, despite the contretemps of the Northern Gateway (or maybe Arctic Gateway or Eastern Gateway) oil pipeline in Canada and the US side of the Canada/US Keystone XL pipeline project. Oil is a key utility input in all of it’s many forms as is natural gas. I will stay out of the debate on fracking!

The world needs power – from any and all sources so I believe that for long-term holdings, exposure to this part of the economy is important. Short-term, be prepared for some storms in all of the energy sector, and I suspect they will all be of a political making. So some inclusion of energy and utlities makes some sense – the amount you include depends on your investment comfort level and time-horizon.

Communications in all of it’s forms will continue to grow although I suspect it too will be choppy due to anti-trust, patent issues and regulatory meddling on one level or another. Manufacturing and transportation industries should experience reasonable grow as I believe that deficit and national debts will gradually be controlled allowing economies to begin expanding again.

Whether doing your equities on a do-it-yourself basis or using some form of managed funds or ETFs, I would be staying blue-chip common shares and preferreds particularly for the risk-adverse.

Short-term interest rates (10 years and less), I believe will stay within about 1% to 1.5% of curent levels, which is positive for everyone including companies loooking to expand their operations. If doing things on your own, I recommend GIC or GIA ladders and if you are going the managed fund or ETF route, then I would be looking at average term-to-maturity south of 10 years and only A or better ratings – BBB if you feel adventurous.

On the pure cash side of things, whether in a bank account, T-bill account or some life insurance cash values, it seems to make sense to hold somewhere in the 5% to 7% range – both for protection and any buying opportunities that present themselves.

On Precious Metals – flip a coin! From everything I can find, the “experts” are about evenly divided on direction and potential upside/downside movement. Some level of exposure would seem reasonable if you can tolerate the earthquake-style market reactions but for these I would personally stay on the managed money side and look for broad diversification across countries keeping in mind political situations and I wouldn’t be comfortable holding more than 4% to 5% and only then if I was looking in the 10 plus-year holding range.

Think positive about yourself and your family, keep personal debts going DOWN and by wise in your discretionary spending in 2013!