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Getting soaked

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The only way to describe it is ‘prison’. The mutual fund prison. Salesguys who masquerade as financial advisors love it. Because it works.

This is exactly what DSC – deferred sales charge – mutual funds are intended to do. Lock you up for a seven-year sentence. The clever idea is that instead of shelling out a commission upfront to some friend of your nephew’s BIL who just got a job slagging funds, you get to buy them ‘for free’. Each year you hang in there, the penalty for bailing out dwindles. After 72 months, it’s gone. You’re paroled. Freedom.

Why would a financial asset you’d invested in penalize you for selling it? Because if the prison didn’t exist, you’d probably bail as soon as you discovered you’re paying 2%, 2.5% or even more in recurring charges to own it. Human nature being what it is, the salesguys know investors would rather spend two years paying huge MERs (that stands for Management Expense Ratios – code for ‘fees’) which they don’t see, than shell out a fraction of that to leave.

Yes, the financial business runs on fees. It’s why the banks are money machines, clearing $40 billion a year in profits. Mutual funds are hugely profitable, and together we hold $1.47 trillion in them. That’s ten times the amount of money that’s held in exchange-traded funds, where fees are ten times less. Obviously millions of Canadians have been guided down this path by that temptress known as TNL@TB.

I thought about this whole fees thing when Rob sent me this note:

Hi Garth, I will make this quick because I know that you are busy. Basically came across an article about what fees are deductible and which are not. Maybe you could do a Blog post on the subject one night. The article makes it sound like most fees are not tax deductible, and to top it off, it seems some rules are changing on January 1 2018

Here are a few things to remember. First, on mutual funds (since most people own them): fees are significant, and buried in the cost of ownership. The person selling you these animals at the bank will tell you s/he doesn’t charge anything to perform that charitable service. In reality, the funds turn out trailer fees so every month you stay invested, somebody gets paid. To Rob’s point, mutual fund fees aren’t tax-deductible. So if you own a fund with a 2.5% MER and you’re in the 40% tax bracket, that’s actually costing 3.5%. Ouch.

The same principle applies to ETFs, all of which have embedded fees which are not deductible. The big difference is the average fee across a portfolio made up of exchange-traded funds might be 0.2% – or one tenth of the cost of owning a mutual.

What about other fees and investment costs?

Management fees, charged by fee-based advisors, are 100% deductible from taxable income on non-registered accounts. With RRSPs, the money taken to pay an advisor is not counted as taxable income. That means you got a tax break for putting that in, but there’s no tax when it exits – so the government is also subsidizing you. Fees on TFSAs, however, are non-deductible. Somebody in the top tax bracket, then, with accounts run by a professional offering tax advice and portfolio management who charges 1% will end up paying closer to 0.6% – while the poor single Mom with a few grand in the bank’s funds will shell out 2.6%. Unfair? You bet. But that’s the law.

So, fees are deductible. Commissions are not. MERs are embedded, invisible and can kill returns. If you remember just those three facts, they’ll serve you well.

Until now it’s also been possible to have fees for TFSAs, for example, deducted from non-registered accounts so they all become write-offs. But that party ends next month. Starting in 2018 investors with different kinds of accounts will see their monthly charges taken from each. Hopefully they will all come from bountiful growth – which is a goal.

How about loans?

These days you can borrow on your secured line of credit for prime plus a half, or 3.7%. That’s fully deductible if you use the loan to invest. So someone in the top bracket will actually borrow at an effective rate of about 1.8%, and this year would earn 9.5% (before tax) on a balanced portfolio. How is that a bad deal? (Of course leverage magnifies risk and can cause marital mayhem. Govern yourself accordingly.)

Some advisors will tell you investment loans are only tax-deductible if the money is used to earn actual income (interest, dividends) as opposed to buying stuff that goes up in value (capital gains). In the real world, that’s hokum. The CRA will never enforce this arcane tax code verbiage for average investors. So, if you have a house with a mortgage on it and an investment portfolio of equal value, sell the financial stuff, pay off the mortgage, take a new mortgage and buy back the assets. Now you have 100% tax-deductible mortgage interest.

A final rule: Do not send Bill Morneau this post.


Source: http://www.greaterfool.ca/2017/11/23/getting-soaked/


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