The Smith Manouevre – Cash Damming’s Aggressive Younger Brother
Are you someone who enjoys playing the stock market, looking to reduce your taxes and willing to take some risks? If you have answered yes to all of the above, the Smith Manouevre might be the thing for you. This strategy takes advantage of the equity in your home, cheap, deductible interest and how dividends and capital gains are taxed to build a tax-efficient investment portfolio that hopefully puts you well down the road to financial independence.
Unlike cash damming, the Smith Manouevre isn’t a pure tax play; it is also an investment strategy whose success largely depends on the kind cooperation of the investment gods. It also riskier than cash damming for another reason; while cash damming ultimately strives to get the client out of debt as soon as possible, the Smith Manouevre is more concerned about building up an investment portfolio than getting out of debt. In fact, someone using the Smith Manouevre might actually have the same amount of debt they started with many years into the plan, although the strategy will have also hopefully produced more than enough investment capital to pay off the debt by that point, with cash to spare.
If all of this sounds vague and hard to follow, then let’s look under the hood and see how this all works. Here are some of basic principles:
· To begin, this strategy is designed for homeowners who like to invest but who can’t really dabble in the market other than through their registered plans because of mortgage payments and other expenses. I see this strategy as a supplement to maximizing RRSP contributions rather than as an alternative.
· It takes advantage of the additional equity you create in your home every time that you make a mortgage payment. Of course, only part of each payment creates additional equity in your home, as part of the payment merely goes to interest charges.
· It works best with an all-in-one mortgage or readvanceable mortgage that allows you to immediately borrow back the principal component of each mortgage payment.
· Following each mortgage payment, the investor borrows back the principal component and invests it in the stock market. As a result, she still owes as much money as she did before making the mortgage payment but some of that debt is now deductible and she now also has a new asset that she can later sell to reduce her debt. For example, Jill from Victoria pays $2,500 towards her mortgage, of which $2,000 was repayment of principal and $500 was interest. This lowers the balance of her mortgage from $300,000 to $298,000. She immediately turns around and borrows $2,000 back to invest in the stock market. When the dust settles, Jill still has $300,000 in debt ($298,000 on her mortgage and a $2,000 investment loan), but now $2,000 is deductible. She also has $2,000 in investments that she can turn around and sell whenever she likes.
· When investing, Jill picks investments (generally stocks, mutual or segregated funds) that either produce ‘income’ (i.e. pay out interest or dividends) or at least have the potential to produce income in the future. See my earlier article on deductible debt for more information on this point (as well as the concern in some quarters that the CRA might start disallowing the deduction on investments not actually producing an income.) To this point, some people have successfully invested in assets (such as corporate class mutual funds) that produce almost exclusively capital gains.
· Each month, Jill repeats the process. The further she gets into her mortgage, the larger the amount of her $2,500 mortgage payment is directed towards principle, which also increases the amount she can borrow back to invest. When possible, she makes additional mortgage payments that are applied directly against the principal. She borrows back the full value of these payments and puts this money into her non-registered investment account.
· Jill also keeps up the interest payments on the readvanceable line of credit as well. She might do this in a variety of ways. Some institutions may allow her to make additional withdrawals from the line of credit and redeposit them as interest payments. She might also be able to use the dividends or income from her investments to fully or partially pay interest charges. As many dividend paying stocks only make 4 payments yearly, she might need to strategically pick stocks that pay dividends in different months so that she has enough money coming in each month to meet the interest payments. She might also pick ETFs or mutual funds that make monthly payments.
· At tax time each year, Jill claim a deduction for the interest she has paid on her investment loan during the tax year in question. This amount is deducted from all her taxable income, much in the same way that an RRSP contribution is deducted from taxable income.
· Eventually, Jill pays down her original, non-deductible mortgage. At that time, she has a variety of choices. She might sell all or some of her investments to pay down all or some of her investment loan. She might start making monthly payments towards any remaining investment loan with the money that was formerly earmarked for mortgage payments. As well, she could also apply the income from her investments towards the loan. Finally, on another note, she might convert the remaining investment loan to a traditional mortgage to lock in rates.
· When deciding what to do with her investments when she has enough to pay down the mortgage after paying the tax, Jill will need to consider a variety of factors. Although it might be safer to sell her investments at that point, she might decide to hang onto them for tax reasons; unless she has capital losses to apply against the gains, she might have a significant tax bill if she sold them in a single tax year while still working and the capital gain is taxed on top of her work income. As well, by the same token, she might want to keep the tax deduction she gets from her investment loan in place to apply against her other income. Accordingly, if she does plan on selling, she might choose to do so in stages over numerous years so less of the gains are taxed at the highest tax rates. She might also choose to wait until retirement or a low income year when she won’t have to pay as much tax on the gains.
· Hopefully, if everything goes as planned, when Jill is completely debt-free, this happy event has either occurred sooner than it would have if she hadn’t taken the plunge or, if this isn’t the case, the extra investment money she has made along the way still leaves her better off than if she’d just paid down her mortgage in the traditional way.
Why The Smith Manouevre Can Work
The Smith Manouevre taps into your home equity in a tax efficient way so you can invest in the stock market. As discussed in earlier articles, the effective interest rate on the money you borrow to invest is a lot less than it might appear at first glance if you’re in a high tax bracket. For example, if you borrow at 3.5% and are taxed at 43.7%, your effective cost of borrowing is really only about 1.88% when you get your tax refund for that year. To make the Smith Manouevre work for you, your investments’ combined growth and income after taxes would have to exceed 1.88%.
Turning to how your investments will be taxed, our tax system makes it easier to beat the effective borrowing rate by only taxing 50% of any capital gain. If you are in the 43.7% tax bracket, this really means that your capital gain is only taxed at 21.85%. Even better, the tax is only due when you sell the assets or are deemed to sell them according to tax rules. This allows the money you would have paid in taxes to continue working for you and compounding, which can leave you better off when you sell many years down the road than if you had been forced to pay taxes on the growth along the way.
In addition to the tax advantages of capital gains, our government also gives us a tax break on dividends we receive from publically traded Canadian securities. In a nutshell, when we receive these dividends, we are receiving money that was already taxed at the corporate level. For example, if a company earned $100, it would only be able to pay out around $72 in dividends after it paid tax on the original $100. Our federal and provincial governments want to give us credit for all or most (some provinces are stingier than others) of the $28 in taxes already paid at the corporate level. In the more generous provinces, the ultimate goal is for the taxpayers to be in the same tax position they’d be in if they’d earned the original $100 and were taxed on it at their marginal rate. To do this, the government ‘grosses up’ the actual dividend received by 138%. This effectively puts the taxpayer in the same position he would have been in if he’d earned the original $100 (i.e. $72 x 138% is around $100.) The federal and provincial governments then allow you to claim a “dividend tax credit” that gives you credit for most of the $28 the companies have already paid on your behalf.
Translating the last paragraph from the theoretical to the practical, the result is that you will have to pay far less tax for each dollar of dividends you receive in your non-registered account than the write off you get on each dollar you borrow for your investments. In some provinces, taxpayers in the lowest tax bracket actually get additional money back for each dollar of dividends they receive! Put another way, because they are in a lower tax bracket than the companies that issued the dividends, they are essentially refunded all or most of the difference between what the companies paid and what the taxpayer would have paid if he had received the $100 directly.
By way of example, if our friend Jill is in the 43.7% tax bracket, she is really only paying 25.78% on her dividends after doing the adjustments mentioned in the previous paragraph. Fortunately, there is an easier way to calculate your effective tax rate on dividends than going through the calculations described in the previous paragraph; most of the tax rates charts online reduce things to the bottom line tax rate on your behalf. Simply go to a site like http://www.taxtips.ca/marginaltaxrates.htm and find your province and tax bracket. You then look at the “eligible dividends” column (if you’re curious, the non-eligible dividends column also included applies to dividends paid by small businesses using money that was taxed at a special low rate.)
Ways to Make The Smith Manouevre Work for You
If you are excited about the Smith Manouevre, here are a few ideas that increase the odds of things working out in your favour:
· Focus on investments that produce solid, stable investments that produce healthy dividends. Although you might do better if you gamble on a bunch of startup companies with no track record which double overnight, always remember that you are investing with borrowed money. I strongly suggest looking at investments that pay dividends to help you pay the interest charges and take some of the pressure off the investments to produce capital gains; if your dividends cover your interest expenses, any subsequent capital gains will be enough to put you in the black.
· There is nothing that says that you have to invest every dollar in equity you free up each month in mortgage payments. For example, even though Jill’s $2,500 monthly mortgage payment free up $2,000 in equity, she might decide to borrow back only towards the $1,000 towards the Smith Manouevre. This way, she is still slowly reducing her total debt load while also still dabbling in the market. On a similar note, she might want to cap out her investment loan at a set amount in advance and stop borrowing then. Likewise, if she is worried about the market at a later date, she can decide not to invest any new money that month or even sell off some of her existing investments to reduce her investment loan.
· If you already have non-registered investments, consider selling those without significant gains (unless you have offsetting losses to apply against them) to jumpstart the Smith Manouevre. If you have investments losing money, you will need to wait to 31 days after selling to buy them back if you want to lock in the loss and avoid the “superficial loss rules” (although this waiting period doesn’t apply if you want to invest in something different.) By applying the proceeds to your mortgage and then borrowing back the money to invest, you can instantly reduce your effective borrowing costs.
· In addition to protecting your downside by choosing more conservative, dividend paying investments, make sure that you are diversified. If just getting started with a non-registered portfolio, this may mean looking at ETFs, Mutual or Segregated Funds with lower fees so that your success isn’t riding solely on the prospects of one or two stocks. Investors who prefer to own stock directly may wish to put some of their dollars into preferred shares, especially when just starting out, that produce dividends well in excess of their borrowing costs. Although you shouldn’t count on capital gains from these stocks, they still can produce winning results merely from their dividend payouts.
· Consider setting up stop losses (i.e. automatic trading instructions to sell assets if they decline to a set price) if you want to limit the amount of money you could lose if the market turns sour and continue resetting these values if your investments grow to lock in gains. Although selling on a general market downturn might mean losing out if the market corrects, this still might be a worthwhile sacrifice if you are not a big risk-taker, especially if you are still selling at a profit. Although this can be particularly galling when the market is volatile and the price of your stocks bounce back shortly after you sell, sometimes discretion really is the better part of valour – especially when you are investing with borrowed money.
· Design an exit strategy in advance. Using stop loss orders might be part of the solution. As mentioned earlier, you might also want to wait until retirement when you’re in a lower tax bracket to start selling or plan on selling gradually over a few years so that you’re not taxed at the top rate on as many of your gains. There are other concerns to consider as well, such avoiding clawback of your OAS pension and other income-related benefits if you sell after age 65.
· Keep an eye on borrowing rates. As mentioned earlier, you might want to lock in some or all of your investment loan (and your non-deductible mortgage, too, if you haven’t done so already) to protect against rising borrowing costs interfering with your plans. Once you’ve paid down your original mortgage, look at converting at least some of any variable investment loan into a fixed rate mortgage. Although a variable rate mortgage may ultimately have provided a better result, if the Smith Manouevre is already working magic with your retirement plans, why take unnecessary chances?
· Make sure you keep an eye on your cash flow needs, especially when approaching retirement. I am not a big fan of clients carrying any type of debt into retirement. Accordingly, if you are not able to pay down both your mortgage and investment loan prior to retirement, take a long look at unwinding this Manouevre and becoming debt-free over the first few years of retirement, especially if it looks like you will be strapped to continue paying your debts and still go on that trip to Bali. Likewise, it is a wonderful thing if you have other lines of credit, an emergency fund and insurances to protect you if someone loses a job, dies or gets sick so that you aren’t stuck selling investments at the wrong time to meet a cash crunch.
The Smith Manouevre is a strategy that has helped many Canadians take financial control of their lives. On the other hand, at the end of the day, it still largely relies on the cooperation of the stock market; events like the market crashes of 2008 and 2009 are enough to swamp most portfolios. Using some of the strategies mentioned in this article should hopefully minimize the chances of disastrous losses but don’t assume that they will make you completely bullet-proof.
Because my dad asked me to, I also offer a final caution on the risks of leveraging (i.e. investing with borrowed money.) To make things crystal clear, if you borrow money to implement the Smith Manouevre, you will eventually have to repay it. Some of us might pay it back slowly over time while others might pay it down quickly by selling off our investments or other assets. Regardless of how you do so, if your investments decline in value, you will need to make up the difference out of your own pocket. If this happens, you will ultimately be better off if you’d never heard of the Smith Manouevre in the first place!
In the end, I suggest reviewing your investment personality, risk tolerance and financial situation carefully before proceeding and then do so with the help of a professional. If you do go ahead, I then suggest customizing a version of the Smith Manouevre that works for you based on some of the options mentioned above, rather than assuming that you have to borrow every last penny available. Once underway, monitor your investments and financial circumstances, then continue to make whatever changes are necessary along the way that work with your life. Hopefully, not so many years from now, this will turn out to be one of the best financial decisions you have ever made and you’ll be writing your own article for a future generation of investors.