We’re approaching December, when many investors have a look at tax planning for the year ahead. In 1965, when Warren Buffett was still managing his investment partnerships for individuals, he made the following comment on taxes in his annual partnership letter:
More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. One of my friends – a noted West Coast philosopher – maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.
What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound.
What Buffett puts so succinctly is the tendency for the tax tail to wag the investment dog. Although tax is important, creating gains is paramount. A policy of maximizing investment gains should naturally maximize revenue for the tax collector, but only at the lowest legal rate.
Over the years we’ve seen a multitude of primarily tax-driven investments (as opposed to performance-driven investments) with varying results. Most investors have found out the hard way that attempting to save a relatively small amount on taxes can result in a much larger opportunity cost than anticipated. Flow-through shares and labour sponsored funds seem to be the most egregious repeat offenders.
Coming back to the investment side, many investors mistakenly believe that more portfolio turnover (buying and selling) results in tax inefficiency. Before passing judgement we should first consider if it is gains or losses that are being turned over. I’ve found one money management rule has created not only substantial performance, but acts as a relatively good tax strategy as well.
We know that constantly selling one’s winners is not a route to good long term performance. And apart from performance, it creates a lot of potentially taxable gains.
Instead, a strategy that holds winners and actively sells laggards can actually result in relative tax efficiency. That’s because many small realized losses can be systematically applied against potential capital gains. Here’s how: selling and immediately repurchasing enough shares of the winner to offset the many losers maintains the investment view, while increasing the adjusted cost base of the winner. On eventual sale of the winner, the investor would potentially pay less tax because of the higher cost base. Instead of the well-known “tax loss selling”, you can think of this as “tax gain crystallizing.” Please discuss with your accountant before making any changes to your own holdings.
In a year where investors might find some very large winners and some losers in their portfolios, tax efficiency can make a real difference to long term returns. Just don’t get too caught up in trying to beat the tax man. Like a good long-time client once told me, “Ben, I want to pay as much tax as possible, but not a penny more.”
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.