How Investments Make Money
Posted In: Entrepreneurial Wealth Management

We invest money with the expectation it will produce a future return on investments. We use this return to achieve a current or future lifestyle. If your money is not growing, it is shrinking.

In the absence of it growing on trees, we can earn a return on our investments 3 ways: interests (Note: rental income is taxed the same as interest income)dividends and/or capital gains. What is most important is identifying the money you can spend vs. what was earned pre-tax.

If our $100,000 investment returns $10,000, what is most important is how much of that $10,000 we keep.

Corporate Example

Let’s say you make a $100,000 investment which produces a $10,000 return. How much of that $10,000 do you actually keep after-tax?

Over the short-term, the stock market can be volatile and uncertain. As a result, we are usually unable to boost our returns by a significant amount from year-to-year. What we can control, however, is how our investments are taxed. For example, earning $10,000 in interest income is different than earning $10,000 with a capital gain. If earned as interest, you keep less than half. Whereas, with a capital gain, you earn roughly 1.5x more than if you earned as interest.

Compound interest is the 8th wonder of the world. He who understands it, earns it. He who doesn’t… pays it.” – Albert Einstein

The tax on your investment return is the hidden tax that most people/accountants don’t talk about it. While unspoken, it can have a tremendous impact on your spendable dollars. If you want to learn more about optimizing your returns within a tax shelter please reach out to learn more.

The combination of these examples is what we call the tax identity. Your tax identity defines the maximum amount of after-tax dollars available to you. It is common for clients to focus too much attention on the $1,000. This can also apply to business owners who only focus on revenue and not net profit. Making ten million dollars in revenue is fantastic, but if you cannot manage your expenses – you may have zero profits or no spendable money.

Does this mean we should only invest seeking capital gains? No. Investment selection should be based on our income requirements and risk tolerance. Since everyone’s financial picture is different, this is a conversation you need to have with your Certified Financial Planner.

Personal Example

Let’s take an individual who is currently earning a $100,000/year salary and has a marginal tax rate of approximately 40%. Over the past year, their $100,000 investment has produced a return of $10,000. How much do they keep after-tax?

The Net Return column would look a lot better if they used a tax shelter, so what are your personal tax shelters? As an individual, you have your Registered Retirement Savings Account (RRSP) and Tax-Free Savings Account (TFSA). There are pros and cons to each:

The Alternative Tax-Shelter

We can help you set up an alternative option. This option has virtually no restrictions on the amount you can deposit while retaining the same liquidity as cash, and the investment values never go down.

How Can I Learn More?

Allocating your money into different investments requires a strong understanding of taxation. If you are wondering if the alternative tax shelter is right for you, please reach out to our team.

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