Awhile back I introduced a simple rule of growing your net worth: pay or save towards the highest after-tax interest rate first, regardless of what you owe or own. Today I’ll introduce the investment types with respect to taxes and run some numbers using a rental property as an example. Each investment type affects your taxes in different ways and what you choose to do with your money should certainly take your taxes into account.
Several investment types
Broadly speaking, there are five categories of interest-bearing investment types and debts with respect to income tax. Notice that I’m including debts here. This is important, and if you don’t get it please read my post on net worth again. Here is a table with a brief breakdown of their tax implications.
|Non-registered investments||stocks in unregistered accounts, rental properties||Contributions are taxed, income is taxed at different rates depending on whether it is dividend income or capital gains or other distributions / coupon amounts|
|Tax-sheltered investments||TFSA, Roth IRA||Contributions are taxed but withdrawals are not|
|Differed-tax investments||RRSP, 401(k), personal corporation holdings (net of corporate tax)||Contributions are not taxed but withdrawals are|
|Investment loans||rental mortgages, investment leverage||Interest is used to reduce income, often 100%|
|Non-investment debt||home mortgage, credit-card debt||Interest does not reduce income. Please note that in some countries home mortgage interest is tax deductible|
So we have about five investment types. None are inherently better than the other because ‘betterness’ is determined by taxation and taxation is determined by your individual situation.
An example using rental property mortgages
I introduced rental property mortgages in my net worth post because I think they’re a really simple way to clearly demonstrate the rule in action. Rental property mortgages are “investment loans” from the table above which means they’re 100% tax-deductible. Here is a typical example which addresses the case of two people who make different decisions about whether or not to accelerate the payments of a rental property mortgage.
Alice and Bob each own identical rental houses that they purchased with identical $100,000 mortgages at 5% on the same day. Bob accelerates his payments at the beginning to $1058/month, Alice pays her regular 25 year amortization at $582/month. After 10 years, Alice still has a mortgage and Bob has made his last payment. Neither of them have any other debt. Both of them have the exact same income, and thus same highest income tax rate. Here are their rental income statements for the 11th year of ownership.
Alice & Bob’s Year 11 Income Statement
|All other expenses||$1000||$1000|
After 10 years, Bob is reporting a significantly higher net income than Alice and therefore he pays more income tax. If their top tax brackets were 30%, Bob would pay $2700 in tax while Alice would pay less at only $1650. Good job Alice! Actually no. Alice certainly pays less tax, but her after tax income from the property is only $3850 vs. Bob’s much more princely sum of $6300. Bob sacrificed at the beginning by making higher monthly payments and Alice will pay dearly for the rest of her amortization. Read this again. I have spoken to several rental property owners who consistently claim that paying off the rental mortgage is a bad idea because it increases taxes. Of course it does, but it also increases after-tax profit! If you have no other debt but a rental mortgage and you’re not paying it off at an accelerated rate if that rate exceeds the after-tax rate of other possible investments… STOP! Pay off that rental mortgage. Don’t sit on a GIC at 2% if you owe on a mortgage at 4%.
I know some of you are thinking “hold on, Dean”. Bob paid significantly more money on his payments during the first ten years of ownership. You’re right, But Alice still owes over $100k.
Alice & Bob’s Payments
|Total mortgage payments||$69,840||$126,960|
But wait! This example is useful in its own context but like I said in my last post net worth isn’t compartmentalized. Imagine if Bob and Alice both had $100,000 mortgages on their family homes as well at the same 5%. Bob was paying $582 on his house and Alice was paying $1058 on hers. Who’s ahead after 10 years? Well the interest on the home mortgage wasn’t tax-deductible, and Alice owns her home now, but Bob doesn’t. Bob will now pay $1640 per month on his family home and Alice will pay $1640 on her rental (both Bob and Alice know that they should keep paying the same total amount instead of blowing it all on a vacation). Taken together this scenario may first appear like Alice and Bob are in the exact same financial boat, but Bob is in worse shape because he still has to pay tax on that $1640/month whereas Alice still gets to deduct interest expenses, almost $3500 in year 10. At their 30% tax rate, Alice will pay about $1000 less in taxes per year. Short summary: if you have a rental house as well as your own house and they both have similar mortgage rates, pay off your own house first.
Summing it up
Pay or save towards the highest after-tax interest rate first, regardless of what you owe or own. I didn’t dive into all five types of interest in this post or the interactions they have with each other. My goal here is to get you thinking about how income tax affects the things you do with your money. But I’ve discussed specific examples in previous posts (tax-deferral and tax-sheltered) so it’s probably useful to read those if you haven’t already. I hope that all the landlords out there who have rental mortgages and no other debt will start paying off those mortgages faster if they don’t have any other higher-return investments for their cash.