Capital Losses in the Tax-Free Savings Account (TFSA)

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Stephan writes,

“My question is related to the TFSA. I am currently debating whether or not I should trade stocks within a TFSA or an un-registered account. I understand the benefits of having your ROE grow tax-free which is great. However, if I'm not mistaken, the TFSA doesn't allow you to claim your losses against your growth. Of course, I wish every trade was a winning one then the answer would be easy but that's not the case. I consider myself a swing trader so I do not normally hold long position except for a few ETFs. So the question is, is it worth it to trade within a TFSA?”

Stephan,

A TFSA (tax free savings account) is a relatively new savings option for Canadians and many investors are asking themselves this very question when trying to plan how to utilize various investment accounts such as registered savings plans (RSP’s), non-registered investments and a TFSA.

Capital gains are not taxed within the account, but on the other hand an investor is not able to capture capital losses like they are in a non-registered account. For a non-registered portfolio you can match a capital loss against a capital gain to cancel out any taxes paid on gains from a trade or investment. In a TFSA that privilege doesn’t apply so the question you really need to answer for yourself concerns risk.

Capital losses, when investing, are inevitable and every investor should realize this. Whether you lose money due to inflation, a decreasing price of an investment or fees there will always be many opportunities for you to lose a portion of your investment. What a conservative investor wants to do is minimize risk and exposure to losses within a TFSA and maximize the benefits that the TFSA offers.

My initial thoughts are that an investor wants to keep only conservative investments within the TFSA to avoid, as best as they can, any capital losses against that stock, bond, ETF or mutual fund since there’s no downside tax advantage for aggressive trading. This is where an indexed strategy (the couch potato) would perform very well. By investing in index ETF’s and mutual funds and rebalancing each year an investor is not concerning themselves with capital gains or losses but methodically applying a conservative strategy that moves gains from some funds to losses of another. Over time the portfolio grows tax free and your losses are kept to a minimum because you’re simply investing with the market.

If you do choose to invest in individual stocks within the TFSA I would encourage you to choose very conservative stocks that over the long-term have great investment prospects. Large cap companies in the insurance, telecom, utilities and energy industry might be good choices if you have the room in a few years to diversify your portfolio into 10-12 stocks. Until then I would advocate, as I have already, that a TFSA be used as a savings vehicle or for an indexed investment strategy.


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June Update, 2009

June has been a hectic month both professionally and personally as a number of important changes took place in my life.

In June I bought my first house, came closer to the launch date for my new business, bought term life insurance for myself and Claire and had various wedding items to take care of that kept my attention away from the markets and left my portfolios running on autopilot very effectively. June also saw a very important milestone for myself and Triaging My Way To Financial Success.

Readers might have noticed that today the RSS feed count on the right side margin hit 300 for the very first time on this site; an accomplishment I am both proud and humbled by. When I launched this site over two years ago and re-launched the revamped template last summer I didn’t envision the following this website would create with readers from all around the world. For 300 people to commit to reading my content on a regular basis means a lot and I know that there are more who visit the site on a regular basis who don’t subscribe. A big thank you goes out to everyone who has helped support this endeavour.

I’ve also decided to launch TMWTFS on Twitter to help keep readers up to date on my investment related activities with regards to what stocks I’m analyzing, what investment articles I’m reading or other related content.

I also want to take a moment to toot the horn of some important people who’ve helped me this month:

I first want to thank Adrian Ionescu. Adrian is a Financial Services Representative for TD Canada Trust at the Wonderland Road branch in London Ontario that I frequent on a regular basis. Adrian was able to secure a 5 year fixed term mortgage for my first home at the best rate I could find in Canada, 3.64%, which was over 3% better than any rate I was quoted for from a mortgage broker. On a professional basis I respect Adrian very much and highly recommend him for anyone looking for banking, investment or mortgage related services. If anyone is interested in Adrian’s contact information please feel free to E-mail me.

Next I want to extend a big thanks to Glenn Cooke who is an independent insurance broker and owner of Insurance Squared Inc. Glenn was able to quote a very attractive rate for a 20 year term life insurance policy for both myself and Claire. Glenn is licensed to sell insurance in Canada in the provinces of Alberta, B.C., Manitoba, Ontario, P.E.I. and Saskatchewan and is another individual who I respect on a professional basis for his attention to detail, sincerity in recommending products based on each client’s needs and a disclosure of any conflicts of interest in the process of selling insurance. I found his services to be invaluable when comparing insurance products to cover the needs of my family in the future. Glenn can be reached at sales@insurancesquared.com and will be happy to provide any reader with a no obligation quote on a life insurance policy.

Triaging My Way To Financial Success was also mentioned in two articles this month published on the web at Million Dollar Journey and independentinvestor.info. The article posted by Frugal Trader on MDJ was an interview with an investor named John who retired at the age of 31 and talks about his process to achieving financial freedom. Among John’s most read list of financial blogs appeared TMWTFS.

My only two stock transactions to disclose to readers for the month of June was to double my equity position in Baxter International (BAX) at $47.80 and add to my position in Shoppers Drug Mart (SC) at $44.00.

Disclosure: I was not compensated for any referrals or recommendations in this post. I have a financial position in TD Bank (TD).

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ETF Investment Strategy & Board Lots

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Karen writes,

"The gist of my question: Does the concept of board lots apply in trading ETFs and why or why not?

I chose early 2008 to take direct control of my RSP portfolio and move it from a mutual fund company and separate GICs to a single TD online trading account. It turned out to have been a crazy year to implement that decision but I probably rode the losses with less stress than if I had still been wondering whether anyone was paying attention to my money. I knew that I was satisfied with my decisions long-term. My plan was to convert the portfolio from funds and GICs to ETFs. I am retired (early) with a pension and I’m no longer contributing to the RSP but not drawing income from it either. The trades to accomplish the switch had to be done within that closed system of the RSP account.

There was a learning curve but I found the niggling detail practicalities hardest to find information on. Portfolio strategy was the easy part. I set an asset allocation target and then planned sales of the mutual funds one or two at a time to fund purchases of the selected ETFs in quantities of no less than 100 units. I wanted to convert the modest portfolio (about $100,000.) with the fewest possible trades. Where I couldn’t free up enough money for my targets by selling a fund, I “parked” the partial amounts in TD funds which didn’t generate a purchase trading fee. (I still hold two of these waiting for several GICs to mature over the next two years.)

My plan is to hold about 8 ETF’s – perhaps more than I need for portfolio purposes but enough to keep me interested in reading the business section and paying the attention to my investments that I should have been doing long since.

As I continue the switch to ETFs or look at future rebalancing, should I be concerned at all over the number of units of an ETF that I hold (apart from the trading fees)? Do you have any other tips or advice on implementing the trades to convert a portfolio from funds to ETFs?"


Karen,

A board lot is usually a standard number of shares an exchange (TSX, NASDAQ, NYSE, etc) defines as a trading unit. For most equities and ETF’s that trade over $1.00 a lot is a minimum of 100 shares. The reasoning for advocating for a minimum standard number of shares is to improve liquidity and minimize the volatility in spreads (difference between ask and bid prices).

An odd lot is simply any number of shares below the standard board lot. Some brokerages do charge an additional fee for odd lot transactions, but in my experience with TDW I buy a lot of odd lots and have never been charged a penny more than needed. Often an odd lot can get you a better price than a regular limit order can because the odd lot is bundled with others to create a board lot. This difference can be only a few cents, but on 90 shares or so you can save yourself approximately $1.00-$4.00.

Your ETF strategy sounds like it has its roots in the couch potato portfolio strategy which includes, in the global strategy, four ETF’s. Eight is likely an adequate number if you want to diversify a little more, but the key component to follow that you’ve touched on is the rebalancing. This strategy is meant to be a very passive investment approach where regular contributions are made regardless of market actions and rebalancing moves profits from one area to build a stronger position in another. Over time this strategy has proven to be very beneficial to an investor with discipline and the ability to execute trades without emotion.

The only suggestion I would make initially is that you ensure your transaction costs (commission) are less than 1.5% of your purchase. If your trading fees are $20/trade then you want to ensure the amount you’re purchasing/selling is more than $1350. Ideally you want to keep your transaction costs (as a % of your trade) below 1% but setting a threshold is an important decision to help you limit your trading and executing on strategy. Obviously if you have a portfolio over $200,000 and you’re making a rebalance each year of $5,000 your transaction cost is only 0.4% but the principle I’m trying to outline still stands.

Your decision to implement the plan over time as your GIC’s mature will also help to build the necessary discipline to implement this strategy effectively over time. Many investors allow their emotions or impatience to win out and setting a plan will often yield higher returns than rushing into something you’re not fully prepared to initiate.


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Mailbag: TD Canadian Bond Index Fund (TDB909)

Recently in the comments of The Bond Guide – Investment Guide to Corporate Bonds

Jordan wrote,

“Thanks for the great information. I have one question. I have owned the TD Bond Index Fund (TDB909) for a number of years. During that time, the fund is always close to book value. I would have thought that, as interest rates have fallen over the past months (many months) that the market value of the fund would have increased. Nobody has been able to explain this to me and I am starting to wonder why I don't sell them and purchase corporate bonds directly. I would appreciate any information.”

Jordan has a few concerns that deal with more than one question related to the TD Canadian Bond Index Fund (TDB909).

For readers not familiar with TD Bank’s index funds they are a series of low cost no-load mutual funds that track specific indices that can be purchased and sold through most investment advisors and there is an E-series of the funds available only through TD at a lower cost.

These funds include:

Canadian Equities (TSX)
TD Canadian Index - I: MER: 0.84%
TD Canadian Index - E: MER: 0.31%

US Equities (S&P500)
TD US Index - I: MER: 0.53%
TD US Index - E: MER: 0.33%

Canadian Bonds (TSX DEX Universe Bond)
TD Canadian Bond Index - I: MER: 0.79%
TD Canadian Bond Index - E: MER: 0.48%

International Equities (MSCI EAFE)
TD International Index - I: MER: 1.31%
TD International Index - E: MER: 0.48%

* Currency Hedged versions of both US and International funds are also available


The fund Jordan is referring to is TDB909 or the TD Canadian Bond Index-E fund which has an MER of 0.48% and is one of the most affordable methods of gaining access to a broad collection of high quality bonds for an investor seeking to invest in the fixed income allocation of their portfolio.

TDB909 is a very conservatively run bond fund focused on achieving monthly income for its holders and has traditionally paid out all distributions as interest with minimal capital gains. The fund is intended to target conservative investors looking to preserve their capital while achieving a modest return in the form of income. Investing in TDB909 and investing in individual corporate bonds are at two different spectrums of risk and investing in one or the other depends on risk tolerance.

When you look at the holdings of TDB909 you get a very clear picture of the fund and how it’s organized for investors. The fund has 50% of its assets in 1-5 year bonds, 18.5% in 5-10 year bonds and 30.4% in 10-20+ year bonds which means the fund is heavily weighted to longer term interest rates. We’ve seen a lot of movement in short-term interest rates, but not a substantial move in longer term rates and this is likely why you haven’t seen a massive price jump in the valuation of the mutual fund units. 50% in short-term bonds is substantial, but the fund is balanced enough to not move in one direction or another in any significant way to protect investors from interest rate risks.

When you examine the funds’ Top 25 holdings (36.4% of the portfolio) you quickly see that it’s dominated by government and Canadian Housing Trust bonds. Overall 46.7% of the fund is placed in Federal bonds, 27.3% in Provincial bonds and only 27.3% in investment grade corporate bonds. As James Hymas commented in The Bond Guide there is a trade-off on premium any investor takes for safety when investing in government bonds that can decrease the yield you receive for less risk and increased liquidity.

The performance of TDB909 over the past year has been pretty good considering the volatility in both interest rates and the markets since the credit crisis peaked. From August 2008 to May 2009 the fund was up approximately 3.9% (not including distributions) which matches its mandate of conservative management of fixed income assets. The fund has also handily outperformed the Canadian Fixed Income Peer Index over that same time period.

Bond funds trade close to book value because of the nature of how bonds are valued. For any specific company there is an intrinsic value based on assets and operations. A bond has a value based on credit quality and interest rates. Comparing the two different assets on their increases in book value isn’t an apple to apples comparison.

Corporate bonds certainly have the potential of achieving higher returns than very conservative government bonds, but there are proportionally higher risks an investor takes (company, credit, liquidity, interest, etc) that I spoke to in The Bond Guide that you are exposed to at a greater degree when you invest in individual corporate bonds.

Whether to sell your TBD909 holding and invest into individual corporate bonds for higher returns is a risk vs. reward question that I can’t answer for Jordan. His/her decision isn’t a simple one and understanding the risks taken with individual bonds should be seriously considered.

A corporate bond ETF (XCB) is one option for Jordan who is looking to gain passive exposure to corporate bonds without taking on all of the risk associated with choosing individual bonds.


Disclosure: I own units of TDB909 at the time of this post.

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Stock Tickers & Dividends

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Mark writes,

“I would like to see a lesson that explains how to use a basic stock ticker. For example, a step by step breakdown of what each of these terms and numbers mean (http://www.google.com/finance?q=ge).
I would like a simple lesson on how dividends work and how to search for funds/stocks based on dividends.”


Stock Tickers:

For a new investor looking at a finance website that displays stock information can be very overwhelming. For this exercise I’ll explain the information displayed within the red box of this image I’ve taken from Google Finance for GE on June 11th before the markets opened.

General Electric Company trades on the NYSE under the symbol “GE” or what is known as its “ticker”.

The price, $13.40, is the previous day’s close and beneath for most large US companies you’ll see a “pre-market” price that indicates where the stock intends to trade at the market open based on company information and investor activity during inactive periods of the market.

“Open” indicates the first price a share is traded at when the markets open on any given day. If GE announced an increase in profit of 50% this number might jump considerably above the previous day’s close or move in a negative direction for bad news.
“High” indicates the highest price a group of GE shares has been bought and sold at during the current market day.

“Low” indicates the lowest price a group of GE shares has been bought and sold at during the current market day.

“Volume” indicates the total number of shares that have changed hands (either bought or sold) from the market open. For Google Finance this number is displayed as million/day.

“Mkt Cap” stands for market capitalization and is the total value of all publicly traded common shares of the company. To achieve this number you take the total number of outstanding shares (10.59B) and multiply it by the market price ($13.40) to get $141.90B.

“52Wk High” & “52Wk Low” indicate the highest and lowest prices the shares have achieved in any 52 week period (1 year).

“Avg Vol” indicates the average volume (number of shares bought or sold) on any given day. If the volume for June 11th was 500.0M versus the average volume of 93.35M there may be a reason for the increased activity in buying and selling of shares (either good or bad).

“P/E” indicates the price to earnings ratio of the company based on trailing earnings for the past four quarters (1 year). You get this number by dividing the price ($13.40) by earnings per share (EPS: $1.62) to get 8.29.

“F P/E” indicates the forward price to earnings ratio of the company based on anticipated earnings of the company in the future.

“Beta” indicates the beta co-efficient of the shares and demonstrates how correlated the company is to the overall stock market. The market, in general, has a beta of 1.0 and individual stocks will have numbers above or below 1.0. Higher beta stocks (in either direction) tend to have more price volatility (higher degrees of price movements) than the overall market. If the market moves 3% in any direction an investor can expect GE shares to move 4.86% in that same direction.

“EPS” indicates the earnings per share (profit per share) that the company has achieved in the past four quarters (1 year). This number can fluctuate considerably depending on the volatility in quarterly earnings a company experiences.

“Dividend” indicates the yearly dividend (to determine quarterly divide by four) that the company pays out to investors holding common shares.

“Yield” indicates what percentage of the current price ($13.40) is paid to an investor as a dividend.

“Shares” indicates the total number of outstanding shares held by all investors (institutional, individual, etc).


Dividends:

Dividends are payments made by any company (public or private) to shareholders of common or preferred stock. A dividend is essentially an incentive for a company to retain investors by returning a portion of profits back to investors. Profit can be used to re-invest back into a business but many investors look to dividends as an essential component of investing as cash returned to an investor is tangible and companies realize that paying investors for the use of their capital helps to support a strong capital base for operations.

Some governments, such as Canada, offer tax incentives (dividend tax credit) that tax dividends at rates below income taxes providing a further incentive for investors to receive dividends.

Screening for dividends can be done easily in a few ways. For US based stocks Google offers a stock screener that an investor can use to track down companies based solely on their dividend yield. If I wanted to set a threshold (absolute minimum yield) at 3% I can set the screen to a minimum 3% and look at the 759 companies that pay a dividend of 3% or more on all exchanges or specifics such as the NYSE, NASDAQ or AMEX.

For Canadian based stocks globeinvestor offers a stock screener that works essentially the same. You enter the information on yield that you’re searching for and filter through the stocks selected for other criteria.


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Retirement Income Question:

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Don writes,

“I am a recently retired 72 year old living on income from a commercial mortgage that has paid 6% for four years. It is up for renewal this September and I am wondering if I should agree to renew or ask for payout and find an investment advisor or broker to try to at least match this income. I am only moderately experienced with investing so would not try to do it myself. I assume the mortgage could be renewed for at least 6%.”

This is a situation I think many retirees find themselves in when searching for income from any investment and the answer to your question depends on a few important decisions. The two most important questions you want to ask yourself are “What amount of risk am I willing to take for the income I need?” and “What alternatives do I have to maintain my income?”

A commercial property that is worth $1,000,000 and pays out 6% through a lease or mortgage could provide you with a pre-tax income of $60,000 per year. If the property is paid off (you own it), you have little in the way of maintenance or management and the property is of very high quality than continuing with leasing the property for 6% could be very desirable for your lifestyle. If you’re lending the mortgage to an individual or company than determining the financial strength of the individual paying the mortgage is very important in this economic climate and I would consider looking at their operations very seriously.

The difficulty I’ll convey to you is choosing between a single investment (your current commercial property/mortgage) and a diversified mix of investments through a financial advisor. A diversified portfolio of income paying stocks, income trusts and bonds would reduce your non-systemic risk (the risk of any single investment) versus what you currently have for income. If you were to hold onto your real estate property as your single investment than your portfolio would be directly exposed to the real estate market; whether it went up, down or sideways or directly exposed to the person you've lent the mortgage to. Your potential for capital appreciation is limited to that single investment and the property may require maintenance to maintain it in the future reducing your net gains or the lender may fail to pay and be foreclosed upon bringing legal fees with it.

In contrast a diversified portfolio through an advisor may expose you to higher fees and achieving a balanced 6% may be more difficult depending on your asset allocation. In an environment where safe government bonds and GIC’s pay very little interest corporate bonds do pay in excess of 5-6% but you’re taking on more risk than you may want for your age. At a 70/30 split between bonds and equity you’re still very exposed to the stock market which while showing strength recently isn’t a sure bet for significant future gains or safe income payments via dividends.

The other dilemma you want to consider is the potential for the mortgage to be renewed at a significantly lower interest rate. If the mortgage was renewed at 4% how would that impact your current income and decision to invest in a diversified portfolio since you mentioned in your question that you are living on the income from this property?

This is a situation where I think you would benefit from sitting down on your own (or with family) and discussing the pros and cons to each option. I would still recommend you seek financial advice from a reputable professional, but keep in mind what fits best for you for your risk tolerance, time and peace of mind.


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The Ultimate DRIP-folio

There’s been a lot of action in the DRIP (dividend re-investment plan) environment recently with a large number of companies rushing to offer DRIP plans to investors and/or promote their DRIP plans with attractive discounts as conserving cash becomes vital.

In one example Canadian banks such as Royal Bank (RY), Bank of Montreal (BMO) and TD Bank (TD) have recently updated or initiated DRIP plans for their investors and an every growing number of Canadian dividend stock paying companies are following suit.

I want, with the help of readers and investors, to create The Ultimate DRIP-folio; a diversified portfolio of stocks that have eligible DRIPs. This portfolio could be the standard among all investors interested in constructing a portfolio that takes advantage of DRIPs and compounding returns over the long-term.

If you’re interested in participating submit in the comments section your top five CDN eligible DRIP stocks, with the details (discount, DRIP or SPP, etc), and I will compile a list and publish it on my site for future discussion of which stocks to include in The Ultimate DRIP-folio and why.

Here’s a list to get readers started:




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Where To Put My Retirement Investments:

Thanks to everyone who participated in The Personal Finance Clinic during the month of May. We received a total of 27 questions that myself, the moneygardener and Canadian Capitalist will be answering over the next while.

Today’s question comes from Adam,

“I'd like to see a step-by-step on where to put my investments. Should I first max out RRSPs, then put it in the TFSA and if anything is left over (probably not) use a non-registered account? Do you have a ‘put your investments here’ guide as to where to place certain investments? I'm primarily a dividend income investor sprinkled with some index funds. I assume I should have all these in my RRSP until maxed and the put the remaining div. producing stocks in a non-registered. Is there ever a time where I should put div stocks outside of an RRSP even if I have contribution room?”

First Adam I’ll point you towards a post I wrote in April titled, Determining a Master Portfolio Allocation, which outlines my experience with developing a plan for investing, as a Canadian investor, in a Registered Savings Plan (RSP), Non-Registered Portfolio and Tax Free Savings Account (TFSA).

The first question you need to answer about maxing out your RRSP’s is what marginal tax rate your income is currently taxed at. If you make over $65,000 per year in 2009 and live in Ontario your marginal tax rate on income will be 32.98%. If you contribute the maximum amount you’re allowed, 18% of your 2008 annual income or $21,000.00, you can expect to receive a return from an RSP investment of approximately 32.98%. The benefit of contributing to a RSP is that your contributions are eligible for a tax rebate at your marginal tax rate, all gains are compounded on a tax deferred basis and US based dividends are exempt from withholding tax.

The main drawback, in your situation, is that any Canadian dividends you receive aren’t eligible for the dividend tax credit within a RSP. If you held all your Canadian dividends outside your RSP in a non-registered account you would only pay 7.45% tax on those dividends when making $65,000 versus 32.98% for ordinary income. This is a situation where even if you have contribution room you may want to consider holding Canadian dividend paying stocks outside your RSP or TFSA depending on your income. A great tool to use for calculating the various tax rates on your income is a calculator provided at Walter Harder & Associates. Building a non-registered portfolio of dividend paying stocks is one method I currently use in order to create a tax-efficient income stream for retirement that will hopefully outpace inflation.

Another consideration is if you currently contribute to a pension or will have pension income when you retire at age 65. If you have a pension at retirement you want to be cautious of contributing too much to your RSP early on as I’ve outlined in the post I linked to earlier. At age 71 you are required to convert your RSP into a Registered Retirement Income Fund (RRIF) that the government forces minimum withdrawals upon. If you’re an individual with a pension income of $35,000 and an RSP of $500,000 at age 71 when you convert to a RRIF you would be required to pull out $36,900 from your RRIF. That would bring your total taxable income to $71,900 and a marginal tax rate of 32.98%. The goal, for any investor building a RSP, is to contribute to a RSP when your marginal tax rate is high and pull from the RSP during retirement when your marginal tax rate is low.

I’m a strong proponent of developing a balance between RSP’s, a TFSA and non-registered portfolio depending on your situation. I will have a defined benefit plan (DBP) at retirement for the pension I currently contribute to and as I’ve shared in Determining a Master Portfolio Allocation I don’t intend to have too much money in any one account for reasons of taxation at age 71. Achieving both a balance and flexibility in my taxable income during retirement is one goal that I take seriously in my financial planning.

What I suggest any investor do is carefully consider your personal financial situation at this moment and your financial situation at retirement. Contributing to an RSP without any pension is a great way to build up savings for retirement, but the new TFSA will start to play a key role in future years as an effective savings vehicle and the opportunity for the Canadian dividend tax credit in a non-registered portfolio is something you will want to consider. What works best for you will depend on your unique situation and seeking professional advice to get you started may be a good option.

Adam: Take your time to consider all your alternatives and don’t be afraid to think independently and outside the box in order to find the right solution. If you have further questions please feel free to comment at the end of this post of contact me and I will follow up with another post answering your questions.

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