(This is a post series on a complicated topic. I will be the first to say debt is an incredibly emotional concept and there is no “right answer” for anyone. Similar to my discussions around asset allocation to bonds/equities, each individual has to take stock of their own behavior when it comes to both debt and stock market volatility.
Despite the above, I believe there is typically a theoretical optimal approach if an unemotional robot were to apply financial models to an analysis for any given set of variables. My goal here is to help readers understand each variable and their individual importance weighting on a multivariate problem. Once you understand the practical data, you can meld it with your emotional behavior to optimize your individual situation.
Hope you enjoy – this will be a long one over several posts so bear with me! This is post #4 of the series – it is essential to have read these first!
The next potential negative outcome of the Rent to Own retirement portfolio would be ignoring tax implications. All the scenarios I discussed in prior posts had uninterrupted compound growth for many years.
It is very common to have some degree of tax leakage in an investment portfolio. This will occur if any capital gains, dividends or interest income is generated on a yearly basis from the investments.
To make the comparison fair among the different scenarios, it is easiest to imagine the whole portfolio is NOT in tax-advantaged account like an RRSP/TFSA/RESP or corporate tax deferred accounts. A non-registered personal account for Jane would be the easiest way to evaluate any differences.
I think the following 3 effects would result from tax leakage in the multiple scenarios of the thought experiment of Rent To Own Jane:
- Time Horizon Leakage – Tax leakage would slightly reduce the portfolios of the longer compounding time periods of 30 yr vs 20 yr on a relative basis. Since the longer 30 yr period will have stronger compounding effects, taking a couple percent away in taxes each year will reduce the final portfolio amount. Tax leakage will still affect the 20 yr portfolio, but to a smaller degree.
I think it is fair to say most of us would pick the larger portfolio amount accrued over the 30 year portfolios vs the 20 year even if it meant some tax leakage along the way. Both Rent to Own and Early Savings Jane 30 year would be equally affected by time horizon leakage.
2. Larger Initial Capital Leakage – The Rent To Own Jane Portfolio consistently has a larger amount invested in initial capital compared to the other examples. This would again mean a higher degree of tax leakage earlier on relative to the other scenarios
a)For example if we compare Rent to Own 30 yr Jane at $500K total invested and the portfolio created a 2% dividend yield = $10K dividend in year 1.
Assuming a 30% dividend tax rate at the highest marginal personal tax rate, Rent to Own Jane would pay $3K in tax and keep $7K.
b) Early Savings 30 yr Jane had only $100K total invested and at 2% dividend yield = $2K dividend in year 1.
Assuming a 30% dividend tax rate at the highest marginal personal tax rate, Early Savings 30 yr Jane would pay $600 tax and keep $1400.
The larger amount of tax paid early on in the investment process, the greater the effect of tax leakage. It is very difficult to numerically recreate this in an analysis, but you can assume Rent to Own Jane has some lowering of her compounded amount secondary to this effect. I will circle back to this at the end.
3. Final Capital Gains Tax Leakage – In all the scenarios, whichever portfolio achieved the best final return would of course have the highest potential final capital gains tax. This is less about tax leakage then final taxes at retirement.
The final taxation will work against Rent To Own Jane a bit in the 7-8% return environment and is neutral in the 4-5% return environment.
This is kind of obvious, but you should always want a higher portfolio amount over a lower one, regardless of the taxation cost.
Rent To Own Jane has more things working against her then for her when it comes to tax leakage. I can’t be precise in the exact dollar amount lost unfortunately. My instincts tell me this wouldn’t dramatically effect the actual ranking order of the final portfolio outcomes, but it would certainly mute the differences a small percent.
Luckily, there is now an easy way to avoid the tax leakage however. There are tax efficient ETF’s such as Horizons that will avoid any distribution of income during the capital accumulation stage. It’s too much to explore the details on tax efficient investing in this post, but I will certainly explore this in other posts. My financial blogging buddy Loonie Doctor already did a great post on this here.
(Edit: see Loonie Doc’s comments regarding the swap based ETF ‘s NOT being eligible for tax deductibility on investment loans)
If this style of tax efficient compounding was utilized, you could ignore the first two scenarios and just be stuck with the problem of a higher portfolio amount to pay taxes on. I can think of worse problems to have!
What About Tax Deductibility?
Taxes seemed like a real downside for Rent To Own Jane, but it is actually the opposite. I believe it can be one of the biggest factors that further tip the scale for Rent To Own Jane in most scenarios.
Most professionals are used to the features of their student and mortgage debt, but are unaware of investment debt which has a big structural difference. Investment interest cost is TAX DEDUCTIBLE. This is assuming that the investment is held in a Non-Registered Account (Not a TFSA,RRSP or RESP) similar to the tax leakage discussion above.
The easiest way to see what tax deductibility can do is to re-visit the previous scenarios discussed in Post 2 and 3.
A) Rent To Own Jane with investment returns of 4-5% vs the interest rate of 5% and a total interest cost of ~$370K over 30 years.
The reality of a loan structure is that you pay higher amounts of interest in the early years relative to latter years when the loan balance has decreased substantially.
For simplicity sake, I will assume the total interest cost was equal weighted over 30 years:
$370K / 30 years = ~$12333/ year.
For a higher income earning professional, I will assume a personal income of $130K for a top tax bracket of ~40%.
The $12333 interest cost is deducted from the gross income amount ($130K)and lowers to a new net income taxable of $118K.
The actual tax savings from this event is $12K x 40% = ~$5000/ year!
This would be a tax refund received every year the interest cost was present. Now this tax refund could be used to “top up” the investment account or pay down the principal debt faster.
My opinion is that re-investing the refund is a great choice. Let’s revisit the same chart when I add in the re-invested refund for Rent To Own Jane (I included Rent To Own Jane without it to remember what the old tables looked like)
|Rent to Own Jane 30 yr (Tax Deduction Re-invested)||Rent To Own Jane 30 yr (No Tax Deduction)||Early Savings Jane 30 yr||Delayed but Double Savings Jane 20 yr||Delayed Savings Jane 20 yr|
|4% return/ 5% interest||$1.9 million||$1.62 million||$1.78 million||$1.77 million||$0.94 million|
|5% return/ 5% interest||$2.5 million||$2.16 million||$2.17 million||$2 million||$1.13 million|
Rent to Own actually WINS when re-investing the tax return in both the 4-5% return scenarios despite not beating the interest cost! It doubles up the portfolio amount of the standard 20 yr Delayed Jane scenario.
You can see that the re-invested tax deduction really supercharges the investment return in this scenario. Remember that this is a GUARANTEED outcome of a tax deductible loan based on tax law. This is not some sketchy process that the CRA will be auditing you about. It will always reduce your taxable income by the total yearly interest – whether you choose to pay down debt faster with the tax refund or re-invest it is up to you. If only student and housing debt could have this advantage!
B) Rent to Own Jane with Tax Refund Re-invested at 7-8% returns and 5% Interest Cost
In my original example of 7-8% investment returns with 5% interest, I had stated that the out performance between Rent to Own 30 yr vs Early Savings 30 yr was nothing to write home about. What about if Jane re-invested her tax refund of $5K/year in this scenario?
|Rent To Own Jane 30 yr (Tax Deduction Re-Invested)||Rent To Own Jane 30 yr (No Tax Deduction)||Early Savings Jane 30 yr||Delayed but Double Savings Jane 20 yr||Delayed Savings Jane 20 yr|
|7% return||$4.3 million||$3.8 million||$3.25 million||$2.55 million||$1.47 million|
|8% return||$5.6 million||$5 million||$4 million||$2.85 million||$1.68 million|
Now this return difference is more meaningful! Even with a 1% lower return, Rent to Own 7% beats Early Savings 8%!
C) Rent To Own Jane with 5% Returns and 7-8% Interest Cost
The high interest rate example from last post was structured to prove that it appears to be a less meaningful variable compared to the early start at compound interest. Despite this proof, you can recall that Early Savings clearly beat Rent to Own by a decent margin when the return was 5% and interest cost was 7-8%.
What happens when I reinvest the tax refund in this dreadful Rent To Own scenario though?
7% interest = $548K total interest over 30 years or $18,266/yr equally weighted
$18226 x 40% tax bracket = ~$7300 refund/yr
8% interest = $644K total interest over 30 years or ~$21500/yr
$21500 x 40% tax bracket = $8600 refund/yr
Reinvest those refunds at 5%/yr return and we get final retirement portfolios of:
|Rent To Own Jane 30 yr (Tax Deduction Re-Invested)||Rent To Own Jane 30 yr (No Tax Deduction)||Early Saving Jane 30 yr||Delayed Saving Jane 20 yr||Delayed but Double Savings Jane 20 yr|
|5% return/ 7% interest cost||$2.65 million||$2.16 million||$2.58 million||$2.43 million||$1.35 million|
|5% return/ 8% interest cost||$2.73 million||$2.16 million||$2.8 million||$2.65 million||$1.46 million|
Is anyone else doing a total financial geek jaw drop here????
Rent To Own Jane has ended up with the best outcome when factoring in the re-invested yearly tax refunds. This is true for all scenarios except the 5% return/ 8% interest cost where it essentially is equal to Early Savings Jane 30 yr. This is despite investment returns losing out to the interest cost by 2-3% OVER 30 YEARS!
The last post already discussed why I think this scenario is already very unlikely to play out over a 20+ year time frame given historical data. There is also the structural characteristics of stocks that have an inflation protection mechanism built into them to keep their growth above bond rates long term (the ability for businesses to raise prices with inflation)
I find it reassuring to know that even in a situation that is very unlikely, Rent To Own Jane not only holds up, but can end up ahead purely from the larger amount of early invested capital.
Balancing the Tax Leakage Downside
A reasonable critique of this analysis so far is that I couldn’t create an objective decrease in portfolio value from the tax leakage effect that would disproportionately affect Rent To Own Jane, yet I have fully given objective math to the upside of the tax refund.
I do think there is another factor that would balance this effect however. I previously mentioned that I am equally weighting the total interest cost by dividing it over 30 years for Rent to Own Jane. The reality is interest cost is heavily front-weighted as shown in the below graph:
If I chose to not equal weight the total interest cost over 30 years, the Rent to Own returns would be slightly higher. For example, in the 5% interest cost scenarios, The first year’s interest cost would be closer to $18K vs the equally weighted $12K, which means a larger tax refund of $7200 vs $5000 in year 1.
My feeling is that the net negative of tax leakage is offset by the superior early compounding of the higher tax refunds than in my calculation. You also always have the choice to significantly reduce tax leakage entirely through tax efficient Horizon swap ETF portfolio mentioned above.
So far I have covered four main variables and used the Rent To Own scenario to try and isolate out the importance of each. I then produced a reasonable downside analysis over the last 2 posts to answer the following critiques of the thought experiment mentioned in Post 2:
a) I cherry picked the historical 7-8% returns of an only stock portfolio – what happens if you have lower returns from a more balanced portfolio?
The analysis of 4-5% investment returns while never beating the 5% interest rate for 30 years (a very unlikely event) shows the Rent To Own beats out all other Jane’s with the tax effect included.
Conclusion: Low Downside Concern
b) I cherry picked a 5% interest rate – what if rates went higher?
The analysis shows the Rent To Own Jane at a 5% investment return and 7-8% interest cost beats out all other Jane’s with tax effect included
Conclusion: Low Downside Concern
c) What about tax implications?
The analysis shows the tax deductibility of investment debt versus any tax leakage is likely a net benefit to the investment borrower versus the saver.
Conclusion – Low Downside Concern
d) A fixed interest rate for 30 years doesn’t exist even on a mortgage. How does the unpredictable nature of interest rates factor in?
Review of historical data shows the likelihood of bond yields (interest costs) being higher than stock returns over a 20+ year period is highly unlikely. Even if it were to occur, Rent To Own can outperform even when getting a lower return than the interest cost.
Conclusion – Low Downside Concern
If I were to rank the above variables, I would put them in the following order of importance of their influence/correlation to final retirement portfolio amounts in the Rent to Own scenario.
1)investment time horizon for compound growth
2) investment returns (this assumes you get market-like returns and can’t get heavy outperformance like Warren Buffet)
3) tax effects – leakage and tax refunds from deductibility
4) interest rates
I believe the data shows interest rates are less meaningful to determining final portfolio amount with a long investment time horizon, because they influence the outcome on a simple basis versus the compound growth basis as discussed previously.
I have yet to cover these critiques from Post 2:
- Stocks have far greater volatility then housing and therefore are riskier. Isn’t it unrealistic to think Jane can borrow $400K against $100K asset? (4:1 borrow ratio or 20% down)
- In a realistic world after graduation, the rent to own example has Jane taking a huge amount of debt at age 30 when combined with her student +/-mortgage debt. Isn’t this excessively risky?
- What about Jane’s emotional behaviour with so much borrowed capital?
Interest rates may not have as much influence on determining final portfolio amounts, but both the absolute amount of debt and the correlative interest rate is the PRIMARY factor when evaluating overall downside risk. If not structured properly, the Rent To Own can have horrible effects. This would be similar to taking on too big a mortgage and struggling to make the payments.
The main critique I have received so far on my analysis is the perceived high risk associated with the Rent to Own portfolio and that most professionals start at a NEGATIVE equity situation from their student debt, while Rent to Own Jane is presumed to be starting at a net worth of zero in my thought experiment.
Is there a way to convert student or mortgage debt into a tax deductible form of debt to gain the tax advantage?
I will dive head first into this whole discussion in the next post!