Levered Investing As An Alternative To An RRSP Or TFSA
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Thread: Levered Investing As An Alternative To An RRSP Or TFSA

  1. #1
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    Levered Investing As An Alternative To An RRSP Or TFSA

    http://www.theglobeandmail.com/globe...article543383/

    The above comes from a 2012 article in the G&M by Tim Cestnick.

    Assume you have $5000 aftertax to invest annually, a 20 year time horizon, a 7% rate of return and a marginal tax rate of 46%.

    The first scenario assumes that you put $5000 each year into an RRSP and invest the yearly tax savings in a TFSA. After liquidating the portfolio in 20 years, you have $204.977.

    In the second scenario, you invest the $5000 yearly into an TFSA. In 20 years, you have $204,977.

    In the third scenario, you invest the $5000 yearly into an open account. If on assumes that all returns are cap gains and taxed only at the end of 20 years, you would have $180,832. If the return is yearly interest income with the corresponding taxation, you'd have $145,537.

    In the fourth scenario, you use the $5000 to pay 7% interest on an interest only loan. You'd be able to borrow $71,400. Assume the only tax you pay on the $71,400 will be cap gains tax at the end of 20 years. Assume that you invest the tax savings from the tax deduction in a TFSA. After paying off the loan in 20 years and liquidating the portfolio, you'd have $276,295.

    A reasonable criticism is that assuming the only tax you'd pay would be cap gains tax after 20 years is not realistic. However, the assumption that interest and growth will be the same might be pessimistic. Also, if you invest outside Canada in a TFSA or RRSP, growth may not be tax free.


    http://www.globeinvestor.com/servlet...030129/RRCESTY

    Tim Cestnick wrote a similar article in the preTFSA era. The link is above.

    Assume you have $7500 of aftertax income to invest annually, a 20 year time horizon after which you liquidate the portfolio, an 8% rate of return and a marginal tax rate of 46%.

    In an RRSP, you'd have $322,773 after 20 years.

    In an open account, you'd have $298,776 after 20 years. This assumes that the only tax you'd pay is cap gains tax after 20 years.

    In the third scenario, assume you use the $7500 to pay 7% interest on an interest only loan. You would borrow $107,000. Assume you invest your tax savings from the interest rate deduction each year. After liquidating the portfolio and paying off the loan, you'd have $439,063. Although he doesn't state it, I think there is the assumption that the only tax you'd pay is cap gains tax after 20 years.

    Once again, the assumption that the only tax you'd pay is cap gains tax after 20 years is highly debatable. OTOH, a 1% difference between portfolio growth and interest rate might be pessimistic. And once again, if you invest in an RRSP outside Canada, it may not be tax free.


    There are advantages of an RRSP. You can split RRSP income with your spouse. Your tax rate in 20 years might be lower than your present tax rate (for example, decreased income in 20 years as retired). So a tax savings might be possible, that wouldn't with levered investing. With an RRSP, you're not taking on the risk of leverage. If tax laws were to change, I'd hazard a guess that the interest rate deduction would more likely be hurt than RRSPs. You don't have to be concerned about tax efficiency, as much as you do with open accounts. This gives you more freedom to invest.

    There are advantages of a TFSA. Your tax rate in 20 years might be higher than your present tax rate, which would be to your advantage with a TFSA, but not with levered investing. You're not taking on the risk of leverage. If tax laws were to change, I'd hazard a guess once again that the interest rate deduction would more likely be hurt than RRSPs. As with RRSPs, you don't have to be concerned about tax efficiency, as much as you do with an open account. This gives you more freedom to invest.

    There are advantages to levered investing. The contribution limits of an RRSP/TFSA may be less of an issue with levered investing. There are no forced withdrawals unlike RRSPs, which can cause problems with OAS. You have greater choice, in what you can invest in.


    What I find interesting is that levered investing can be a reasonable alternative to an RRSP or TFSA. That makes sense, because all three are forms of tax advantaged investing.


  2. #2
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    I'll have to work through the details but there seem to be more questionable items than just than have been outlined. I will take a more detailed look when I get more time but here's a few points to consider.

    For scenario #1 - why is there no mention of the $$$ in the TFSA? The point to the comparison was everything one could use, was it not?

    For scenario #4 - CG only looks highly questionable to me. Skipping companies that pay dividends or cash distributions (ex. REIT) means either depending on a swap based product or ignoring large parts of the NA stock markets (ex. want a big six bank? Dividends will be paid).

    There's also that one of the requirements to deduct the loan interest is the "expectation of income". While a stock that does not pay dividends or income is generally accepted by CRA, all it takes to make it in-eligible is a write up saying the company has a policy to not pay dividends/income.

    I also find it interesting that the 2012 article is said to "interest and growth". Some of my purchases since that I have leveraged are paying 3x in dividends what the interest charges are, never mind the capital growth.


    Cheers

  3. #3
    Senior Member kcowan's Avatar
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    Yes you need enough component of dividend/interest producing investments to cover the interest you paid at least. So high payout companies are preferred but you would have missed the big gains in AAPL before they paid anything out.

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  5. #4
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    Did AAPL have an explicit policy to not pay dividends?
    If so, then one would have to avoid buying their shares when deducting interest.

    If AAPL was silent on the matter, CRA generally accepts it.

    1.70 Where an investment does not carry a stated interest or dividend rate, such as some common shares, it is necessary to consider whether the purpose test is met.

    Generally, the CRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that at the time the shares are acquired there is a reasonable expectation that the common shareholder will receive dividends.

    However, it is conceivable that in certain fact situations, such reasonable expectation would not be present. If a corporation has asserted that it does not pay dividends and that dividends are not expected to be paid in the foreseeable future such that shareholders are required to sell their shares in order to realize their value, the purpose test will not be met.

    However, if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met. Each situation must be dealt with on the basis of the particular facts involved.
    http://www.cra-arc.gc.ca/tx/tchncl/n...f6-c1-eng.html

    Example 11 is where the interest deduction would not be allowed (goal is capital return only with a policy to not pay dividends.
    Example 12 is where no dividends are being paid, nor will they be for the foreseeable future but the interest deduction is allowed.


    Point 1.43 where Example 10 outlines that repaying a mixed use loan (ex. some personal non-deductible use, some deductible use) has the non-deductible portion paid off first. Which is why people will work at keeping a particular loan as 100% deductible.


    Cheers


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