I have been keeping an informal record of topics of discussion I’ve had with financial advisors, friends and colleagues over the last couple of years. The following is a list of rules of thumb or misconceptions about investments, tax, and product allocation.
Some items in this list may seem straightforward while other, may be an enlightenment. It highlights the lack of real training and understanding of financial products and concepts by financial advisors.
Yellow Pages Income Fund Does Not Pay Dividends
Yellow Pages distributes income earned by the business inside a trust. While the distributions have contained some eligible dividend income, most of the distributions are straight income (which is taxed just like interest). A look at 2008 distributions shows that 88% of the distributions were investment income, 9% was eligible dividend income and 8% was a return of capital.
Income Trusts Distribute Income (Not Dividends)
Like Yellow Pages, the distributions of any income trust, including REITS, can be a mix of straight business income (which is taxed like interest), a return of capital and may include some eligible and ineligible dividends. Always check the distribution history of any income trust.
Make Decision on After Tax Income
If you are looking at two different investment alternatives, not all are treated equally for tax purposes. For example, for an Ontario resident in the top marginal bracket, a 4% interest receipt, 2.8% eligible dividend and a 2.79% capital gain all have the same after-tax return of 2.14%.
Don’t Put An ADR In An RRSP or RRIF
An ADR is an American Depository Receipt and represents an ownership of the underlying shares of a foreign corporation. They are a derivative product that are offered on U.S. stock exchanges that allow you to buy shares of foreign corporations. The U.S. withholds the maximum foreign withholding tax regardless of the fact it is in an RRSP or RRIF. The withholding is not covered under treaty and is not recoverable.
If you want to buy foreign shares for your RRSP or RRIF, ask your broker to purchase the shares directly on the foreign exchange.
Learn How TFSA Contributions Work
The TFSA contribution room increased by another $5,000 this year. If you never contributed to a TFSA before and were over the age of 18 and were a resident of Canada, you will have $10,000 of room in 2010. I find that many financial advisors have no idea how TFSA contributions work.
A GMWB Is A Segregated Fund With Another Type of Guarantee
If you cash out your GMWB you will lose the reset values. Many financial advisors do not understand this product and promote the GMWB guarantee as a guaranteed rate of return: Which it is not. Take a read through GMWB Case Study And A Suitability Nightmare.
Capital Gains and Losses
The adjusted cost base (ACB) is based on total ownership of a security, not what is held in an individual account. The cost base of an individual stock is it’s average adjusted cost base. This means that if the same stock is held in two brokerage accounts, the ACB is the total amount paid in all accounts, plus all commissions, divided by the total number of shares.
Bonds Can Have Capital Gains & Losses
I was speaking with a financial advisor about how accrued interest worked for tax purposes: It seems he was confusing the concept of bond yield and the actual interest paid. In the course of our conversation, I mention that if the bond were sold or held to maturity that there could be a capital gain or loss depending on whether the bond was bought at a premium or discount. This was shocking news to him.
Strip Bonds Should Only Be In Registered Accounts
If you have ever held a strip bond in your regular open account and have had to calculate the interest income for tax purposes, you know it is not a simple calculation. To save you the headache, hold strips in your RRSP, RRIF or TFSA.
Spousal RRSPs Are Still A Good Idea
If you plan to retire before age 65, the spousal RRSP is an excellent way to split income (pension splitting is not generally available until after age 65). I think the benefit of the spousal RRSP has been lost in light of the new pension splitting rules.
Not Every Defined Benefit Pension Should Be Rolled Over
I have come across financial advisors who seem to think all pensions must be rolled over to a locked in type of account. If fact an assessment of all relevant facts needs to be done to determine if its right for each client.
Your Structured Settlement May Be Really Good
Many financial advisors fail to do a proper analysis of the facts and simply tell their clients to take the insurance payout rather than a structured settlement. I have done many analyses of personal injury structured settlements and have yet to find one where the payout is better. This is not to say, the settlement is always better, but that an analysis must be done in each case.
A Diversified Portfolio Includes Fixed Income
Periodically I have conversations around client portfolio’s and proper diversification. I have come across situations where the equity and fixed income portfolios are constructed independent of one another. Often I find that when the total portfolio is analyzed there tends to be overweighting in a sector or of a particular company. The lesson here is to be aware that holding the shares and bonds of the same company is compromises diversification.
The above is just a brief summary. If you have ideas or would like to ask a question, consider leaving a comment.
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{ 7 comments… read them below or add one }
Great thread. I think there’s a lot of important information for investors and the average tax payer to keep in mind here.
Some notable ares of interest for me was the discussion how the distribution income earned with income trusts are often and mostly treated as interest income and not dividend income (which is treated more favorably). I also have shares in YLO.UN and I didn’t know that that was the exact breakdown in terms of how distributions were treated.
Regarding TFSAs, I think every adult Canadian should take a hard look at TFSAs; I think they’re a great investment vehicle.
Nice paragraph on diversification. I think a lot of investors, despite the fact they very well may have a good concentration of fixed income and equity positions, may have a too high of a percentage of weightings allocated to a particular sector (such as oil & gas) and this could prove to hurt a portfolio’s value in a big way if its not balanced properly.
@The Rat: I speak with financial advisors frequently and the YLO is one where I am surprised they are unaware it does not pay dividends.
One area of underdiversification many overlook is their own home.
Interesting indeed.
When you mention the home, do you mean that underdiversification because investors aren’t buying homes, or because there are borrowing opportunities in relation to one’s home?
I feel that many consider their home an investment. If it were an investment, the historical rate of return after tax, include the incredible amount of cost to maintain the property, is horrible. Further, it is a singe investment and lacks any sort of diversification. I’m of the belief that most should wait to buy a home until they have amassed more savings.
Good post…..
@Tax Guy: Gotcha, i didn’t know what angle you meant by it, but now I understand and see where you’re coming from. Good points.
good helpful post