GICs (Guaranteed Investment Certificates) offer investors attractive features, such as a guarantee on your original investment, along with a fixed interest rate.
Although they are a highly stable investment choice, the interest GICs pay is not the net income you might receive. There are factors that will lessen that payment, namely taxes and inflation.
GICs pay interest income, which is the highest taxable form of investment income, compared to dividends and capital gains. It’s fully taxable at an investor’s marginal tax rate.
A less tangible impact to investment income is inflation. It erodes the value of your money over time; a year from now, $1 will not be able to purchase as much as it would today.
When you deduct taxes and inflation, the net income generated by a GIC can look very different, here is an example:
• GIC interest rate: 2.5 per cent
• Marginal tax rate: 40 per cent
• Inflation rate: 2.51 per cent* (five-year average according to the Bank of Canada, as of Feb. 28, 2022)
Let’s illustrate this by looking at $100,000 put into a GIC and use the above-mentioned number. The $100,000 investment would generate a gross return of 2.5 per cent or $2,500.
If held in a non-registered account and your marginal tax rate is 40 per cent, that would mean taxes will reduce your return by one per cent or $1,000. This leaves you with a 1.5 per cent (or $1,500) return net of taxes.
So, sitting in your investment account at the end of the year would be $101,500.
But then we have to take inflation off as well to determine your true purchasing power remaining. Subtracting the five-year average inflation rate of 2.51 per cent off the remaining one per cent of net return, your actual return net of taxes and inflation on the GIC is -1.01 per cent.
To convert this back to dollar figures, you started the year with $100,000 and then one year later, and after taking taxes and inflation into account, you have the equivalent of $98,990 of purchasing power.
And with inflation rapidly climbing right now, you could argue that the actual purchasing power of what you have left would be even lower.
The expected rate of return versus the real rate of return can end up being vastly different when dealing with low interest-bearing investments and this is why its so important to understand all of the variables of any investment solution that you are contemplating.
To be clear, I am not saying that GICs are always the wrong choice, but they need to be fully understood. Once taxes and inflation are taken into consideration, what was originally a guaranteed positive income stream has now become negative.
With inflation steadily climbing, it is more important than ever to fully understand the impact that it can have.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.