You can't afford to earn interest
The Advocate, November 6, 1996
Can you afford to earn interest? I can't, even at 10 or 12%. I have no investments that earn interest such as mortgages,
GICs, savings accounts (except T-Bill Money Market Funds), no Canada Savings Bonds, or notes and loans to other
people. The reason being, I can't afford to lose purchasing power each year. It has always surprised me that most
people when putting their savings to work, look at only one thing, and that is rate of return. If it's 12%, they think
they will have 12% earnings to spend.
But will they? The second thing to look at is net rate of return after taxes.
That's a very important point. Finally, the third thing to look at is inflation. Those last two points, in the past several
years, have made it a "losing proposition" for me to "earn interest". Let's look at it! If you were to earn 12% a year
in interest (remember the good old days?) and have a taxable income of $30,000 you would be in a combined
federal and provincial tax bracket of 41.9% on any earnings in addition and that includes interest at the full tax rate.
The next tax bracket below that would be 27.4%. The next bracket above would be 44.9%. Anything over $59,181
is 50.1%. Therefore, even at a lower bracket of 41.9% a 12% rate of return would be reduced by 5.2% leaving an
after-tax return of 6.8%. Inflation averaged 5.97% from December 31, 1967 to December 31, 1995. That means
your after-tax, after-inflation "real" rate of return is less than 1%
. If you are in the 50% or higher tax bracket even
that meagre amount is wiped out. At current rates of 6% and less you are effectively lowering your standard of
living, especially if you are relying on that as part of your income. True, you have more dollars, but they buy less.
(See my September 1994 article "A Dollar on a Loaf of Bread" or call me for a copy.) Many people want these
guarantees because they consider them safe. However, earning interest under the above conditions is not really
safe, in fact, it is a guaranteed way to lose.
Now let's suppose you were to earn 12% in capital gains and dividends.
If you were in the $6,759 to $29,590 tax bracket your dividends would come to you practically tax-free. You would
be able to keep $926 out of $1000 in dividends. Because of the dividend tax credit you would also be able to save
taxes on your other earned income. Capital gains on the other hand are 25% tax free. Only 75% are taxable.
In other words, on a capital gain of 12%, only 9% would be taxable at whatever rate you pay. I would prefer
to have a 10% gain in dividends and capital gains than 12% in interest because (thanks to inflation) I would
have more to spend after taxes. Remember, it's your after-tax return that you can spend at the store.
That's
the bottom line! I have heard many people say: "How come no one has ever shown me before the difference
taxation makes in various types of return?" I think the answer is quite simple. Most institutions that we deal
with day after day, such as banks, trust companies, credit unions, deal primarily in one kind of return, and that
is "interest".
You may have noticed recently in my ad in the professional directory that I no longer offer GICs.
I firmly believe if I were to continue to offer them even as a service to my clients, I would be doing them a dis-service.
I am a firm believer in "ownership". As I have explained several times before, investing in the right equity mutual
funds gives you this ownership which produces dividends and capital gains and a superior rate of return.
"Own or loan" is the saying I use to demonstrate this point. (See my November 1993 article "Owning vs. Loaning"
or call me for a copy.) I also have charts and tables that show the after-tax retention of $1,000 in the various
tax brackets plus the inflation rate per year from 1967 to 1995. They are yours for the asking.
If you have any questions, please call Reg Borrow at (519) 855-6639. He is an Independent
Financial Consultant with Regal Capital Planners Ltd.
Money Matters Index
Home Page