Are Risk Free Returns Risky?

By Travis Forman, Portfolio Manager at Strategic Private Wealth Counsel

Amidst financial uncertainties and a rising rate environment, “risk-free” investments, such as government treasury notes & GIC’s, have emerged as a haven for investors seeking stability. While an individual may hold the investment to maturity and realize the intended yield, they may not thoroughly understand their actual profit.

Risk-free rate versus real return

An investment’s?real return?refers to its gain after accounting for inflation and taxes. It reflects the true value of the increase in purchasing power that the investment delivers. For example, if you earn a 5% return, you must still pay taxes on the investment income. You will also lose out on purchasing power due to inflation. Between these two factors, your investment return can quickly dwindle to a real return of 2.5% or less, maybe even 0% or worse. If you expect the 5% risk free return to help meet your financial this could be a problem.

In reality, taxes and inflation depress returns far below investor expectations. Individuals focusing solely on total returns, without considering the real value of their investments, may find themselves surprised by the lack of growth in real terms. This is especially true for risk-free investments, as their perceived safety and return potential are frequently overestimated. For example, many Canadians consider today the “sweet spot” for retirement, as interest rates are now above 5%. Relying on this risk-free rate ignores critical elements like inflation and taxes, which can erode savings over time. As we outlined above, it is the?real?return that matters. So, as you consider an investment, look beyond its stated yield to determine its actual return. ?

How are your investments taxed?

To boost your real return, you can minimize the tax you pay. In Canada, the type of investment return you earn will impact how much tax you owe. Investment return in the country is broken down into the following types:

·?????????Interest income. Interest income is fully taxable, added to your regular income, and taxed at your marginal tax rate. This investment return typically comes from savings accounts, Guaranteed Investment Certificates (GICs), and bonds.

·?????????Capital gains. Only 50% of capital gains are taxable in Canada, with the tax calculation based on your marginal rate. If you sell investments, such as stocks, for a profit, only half of the gain is considered income for tax purposes.

·?????????Return of capital (RoC). Investors seeking yield but are wary of a high annual tax bill can consider investments offering RoC. This type of return is not immediately taxable but reduces the original cost base of the investment. When you sell the asset, the difference between the reduced cost base and the sale price is subject to taxation as a capital gain. Essentially, RoC allows you to delay tax payments and benefit from the preferential tax treatment of capital gains.

As you can see, each type of return has a different tax implication, with some offering more favorable taxation terms than others. If you invest in a non-registered account, your interest income is taxable at a higher rate than your capital gains.?

You can preserve more of your real return by selecting an asset that will provide returns with lower taxes.

How to calculate the real return on your investments (ROI)

To truly understand the impact of inflation and taxes on your investments, let’s examine a few examples based on the different types of investment returns.?

Interest income

Imagine you invested in a one-year GIC offering a 5.5% yield. ??Although this investment is generating an annual yield producing spending money for the investor what does your real return look like? If your marginal tax rate is 40%, you will pay taxes on the interest income at this rate.

In this case, your after-tax return is 3.3%, calculated by taking your 5.5% pre-tax return multiplied by 60% (or 1-0.40), as you will only keep 60% of the proceeds after you pay taxes.

As you can see, your investment gains are already significantly lower than 5.5% before we account for the impact of inflation.

If inflation is assumed to be around 3.5%,?your real return is?negative?-0.20%?(3.3% after-tax return less 3.5% inflation).? Yes correct negative even with a positive return.

This means that after accounting for taxes and inflation, even a posted yield of 5.5% is not as appealing as it sounds.?You are actually losing purchasing power by holding this “risk-free” investment.

Capital gains

Instead of investing in a GIC with interest income, imagine you purchase stocks offering a capital gains return. It is important to remember this type of investment is carries market risk in addition to tax and inflation risk and it has to be sold to generate spending money for the investor.?

In this case, only 50% of the capital gains are taxable, so a 5.5% return would mean you owe taxes on 2.75%. If you are in a 40% tax bracket, your after-tax return would be 4.4%. We calculate this by multiplying the 2.75% taxable portion by 40% to get a tax liability of 1.1%. Then, the full 5.5% return less the tax liability gives us our post-tax return.

Next, we account for a loss of purchasing power due to an inflation rate of 3.5%.?Your real return after inflation would be 0.90%?(4.4% post-tax return less 3.5% inflation) — significantly better than the GIC. Compared to our previous example with interest income, it is obvious why capital gains are the preferred form of investment return within a taxable account.

Return of capital (RoC)

RoC typically generates a quarterly income distribution for investors.? RoC is a great way to generate spending cash.? When you receive a RoC distribution, it is not immediately taxable. Instead, RoC decreases the original cost basis of your investment, with the tax implications coming into play when you sell it.? However, it does not generate taxable income as the years go by until sold.?

For this example, assume an investment that yields a 5.5% return, similar to the previous scenarios, but structured as a RoC distribution. What is the real return if you initially invested $10,000?

A 5.5% RoC would reduce your cost basis by $550 (5.5% of $10,000). If you do not sell the investment this year, there are no current tax implications. For this example, we will not account for future tax as we only focus on this year in our calculations.

Though you will not realize an immediate tax liability with RoC distributions, you must still consider inflation. If inflation is 3.5%,?your real return in the year you receive the distribution would be 2%?(5.5% return less 3.5% inflation).

Based on the three scenarios, you can see that investment returns structured as RoC provide real returns that are significantly higher compared to interest income and even capital gains. This is due to the tax-deferral feature, which can be particularly beneficial for investors seeking to manage their tax liability strategically over time. This is why RoC can be an attractive option, especially for those in higher tax brackets or those looking to defer tax until they have a lower bracket in retirement.

How to maximize your after-tax investment return?

Another way to maximize real return is focusing on favorably taxed investment accounts.? When, considering what assets to own, it is not just about the return type and its taxation. Where you hold these assets can impact how much of your investment return is taken away by taxes. Strategic allocation involves placing higher-taxed investments, such as those that produce interest, in tax-advantaged accounts, such as a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP). You can then hold assets that produce capital gains or return of capital distributions in non-registered accounts, as these investments have lower taxes. This optimization ensures that your investments are growing and doing so efficiently, with a minimized tax burden.

We will continue our example of a GIC yielding 5.5% to understand this concept better. If you were to earn this 5.5% interest income in a non-registered account, then after taxes and inflation, your real return would be -0.20% (as per the calculations completed earlier). Contrast this with a TFSA, where you earn the same 5.5% yield but are not subject to taxation. With a TFSA, taxes do not diminish your real return, so you only need to consider inflation in your calculation.?Your real return from a GIC held in your TFSA would be 2%?(5.5% yield less 3.5% inflation). This shows that keeping the asset in a tax-advantaged account is infinitely better from a real return perspective. In this example, the real return in your TFSA is 2.2% or 240% more real return better for the same asset.