THE BAYWOOD BUSINESS FORUM

This page has been assembled to provide business people and professionals with quick insights to various investment and taxation issues often asked of us during consultations and meetings. As everyone's situation is unique, the suggestions provided should be thoroughly explored with your own personal advisors before being adopted and acted upon.

Donating Stock To Reduce Tax

An attractive alternative to donating money is the donation of publicly traded stocks. The advantage to this type of donation is that 25% of the capital gain is included in income instead of the normal 50%. This is a saving of 50% on the tax. For example you purchased stock for $50,000 and it is now worth $100,000. If you sell the stock you pay tax on 50% of the capital gain of $50,000. The tax at a 50% rate is $12,500. (50,000 x 50% x 50%) On the other hand if you donate the stock you receive a $50,000 tax credit (50% of $100,000) and pay tax on 25% of the capital gain of $50,000. The tax at a 50% rate is $6,250. (50,000 x 25% x 50%) This results in a tax refund of $43,750. ($50,000 - $6,250) So, if you do have stocks with capital gains, save tax and donate the stock instead of cash.

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Using Insurance As An Investment

A number of insurance companies offer policies where Term Insurance and an investment are combined into one package. The investments are chosen from a wide selection of mutual funds having their returns linked to an index such as the Standard & Poor 500, the TSE 300 or offering fixed rates for guaranteed terms such as 1, 3 or 5 years. The insurance component qualifies the concept as a tax shelter. The difference between a taxable and a tax sheltered investment is substantial. If you invest $100 a month for 20 years earning 6% you will accumulate $46,204. If you are in a 50% tax bracket and taxed on these same earnings you will only accumulate $32,830 An increase of $13,374! Look for a policy that has the lowest costs for insurance, administrative expenses and investment management expenses to receive the highest return. It is also important that all these costs are specified and guaranteed not to change so that you avoid any future increases.

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The Administrative Costs of Stocks vs Mutual Funds

Some investment advisors will caution investors about purchasing mutual funds. The reason given is that mutual funds have management expense ratios (MER) of approximately 2.5% each year whereas with stocks, you pay only when you buy or sell. If you buy and sell a stock once a year, on average the total charges are 3%. (That is, 1.5% on purchase and 1.5% on sale) This can be reduced to a simple flat fee if you do your own on-line trading. The longer you hold the stock the lower your cost becomes as its purchase and disposal components become more diluted by the stock's appreciation in value. For example if you hold the stock for two years your cost is approximately 1.5% a year. Most investors will find that the average length of time that a stock is held is less than two years.

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Mutual Funds vs Other Investments

There are many more factors to consider when selecting Mutual Funds over other investments than just the Fund's monthly, annual or 5-year performance record. How long are you able to leave your money invested and how flexible is your withdrawal date? If you require the money in two years to purchase a house and you are not prepared to postpone the purchase, funds are not the right investment. The fund value may be down at that time and you may then not even have your original principal. You are better off putting the money into a guaranteed investment such as a GIC where you know that you will receive your principal plus interest. Do you require income or is your investment solely for growth? If you need income how much income do you need and what percentage does your portfolio need to generate? For example to generate income of $24,000 a year from a $1,000,000 portfolio the rate of return required is 2.4%. Since the rate of return required is so low you may decide to invest primarily in equity funds and make monthly withdrawals. However if your portfolio is $400,000 you need 6% to generate $24,000 a year of income. You may now wish to invest solely in bonds or preferred stocks. If the investment is non registered you may wish to invest in preferred stocks rather than bonds as dividends are taxed at a lower rate than interest. Diversification Each mutual fund invests in different areas. Some of the different types of funds are: An equity fund which invests primarily in stocks, A balanced fund which invests in a mix of stocks and fixed income such as bonds A fixed income fund which may invest in bonds or treasury bills A money market fund A specialty fund which may invest in a sector such as technology, a geographic area such as Europe or companies of a specific size such as companies with large capitalization. The key is not to have too much invested in any one industry sector eg: telecommunications. That way if one sector or geographic area is not doing well it can be offset by the return from the rest of your portfolio. On the other hand, if you over diversify with too many funds you may reduce your potential return. Individual stock holdings in each fund If you do not look carefully at individual stock holdings, you may find that you are actually buying funds built up from similar stocks. For example several funds carry Nortel as their primary Canadian high-tech investment component. If the price of this stock drops, it can negatively impact your portfolio. Fund manager What is the expertise and track history of the fund manager? Has this individual or fund philosophy undergone any significant change recently? Risk and volatility How risky and volatile are the stocks held by that fund?

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Using Other People's Money

Just how risky is it to borrow money to invest? From a taxation viewpoint, provided you are borrowing to invest to earn income the interest is tax deductible even if your investment earnings are the same as your loan interest you are still ahead and making money. Assuming a 50% tax bracket: Borrowed $100,000 Pay the lender 8% Interest ie: $8000 (Tax deductible) After tax cost @ 50% tax bracket is $4000 8% Dividend of Capital Gain on $100,000 (after tax return) $8,000-$2,560 = $5,440 Earned Profit (after tax) $5440-$4,000 = $1,440 What are the risks? Lenders (usually the brokerage firm you are dealing with) will generally lend you a percentage of the investment. If the investment drops in value part of the loan has to be repaid so that the lender has still only loaned you the same percentage of the investment. Assuming a lender will advance 50% of an investment: 50% of $100,00 = $50,000 loan If the investment value drops to $75,000 the lender recalculates advance to $37,500 creating a shortfall of $12,500 to be repaid immediately. This is known as a margin call. The other risk is a change in interest rates as most loans are not at a fixed rate. If your investment is earning 5% and you are paying 12% interest on the loan before tax your after tax loan interest is 6% and you are losing money. One company has finally come up with a solution. Loans are advanced for as much as 80% of the investment. There are no margin calls and loan interest rates can float or be locked in for five year periods.

To Contact Baywood Financial Group: Richard Segal Baywood Financial Group 265 Yorkland Blvd Ste 401 Toronto, Ontario M2J 1S5 Canada Tel (416) 221-1313 Fax (416) 498-4667 Email rsegal@baywoodfinancial.com

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