Obviously you can never eliminate taxes. Even with a twenty year performance comparisons I talked about last week, at some point you will be required to pay taxes on your portfolio. The goal is to keep as much as possible for as long as possible, because a dollar paid to the tax man is a dollar that is no longer working for you.

In our balanced portfolio example, one of the easiest things to do is plan to hold the least tax efficient assets inside tax exempt plans places. For example, hold cash and bonds inside an RRSP, and equity assets outside an RRSP. This allows you to pay less tax in the early years, retaining more money to compound in the future.

If you must hold all of your assets in non-registered accounts, you might look at assets that act like a bond, but that are more tax efficient than a bond. Good quality preferred shares are one example. The cash flow from preferred shares is taxed as dividend income rather than interest income.

Of course preferred shares carry equity type risks, in the sense that the company is under no contractual obligation to pay a preferred dividend. Whereas a bondholder could put a company into default for missing an interest payment, no such restitution exists for the preferred shareholder. Should the underlying company get into financial trouble, and in a worse case scenario become insolvent, preferred shareholders rank ahead of common shareholders, but rank behind bondholders.

Because of that, I would only look at preferred shares issued by blue chip companies that have a long history of paying dividends. In fact, a company that pays a healthy dividend to common shareholders, is a good candidate. Because companies are typically not allowed to pay a common dividend until preferred shareholders receives their dividend. You should also only look at preferred shares with a cumulative feature. This feature means that the company must pay all missed dividends before it can re-instate dividends for the common shareholder.

Despite the fact that preferred shares represent ownership in a company (unlike bonds that represent debts owned by the company) they do not typically participate in the companies growth. What you get is the dividend, and that is all you get. As such, preferred shares tend to act like bonds, in that they rise when interest rates fall and fall when interest rates rise.

Another approach is income trusts. Although these hybrids are much riskier than holding bonds, and as such, you should expect to earn a higher payout. As an income trust, the company agrees to flow its earnings through to the unit holder, which means that very little is retained for future growth.

Companies that transform themselves into income trusts typically have very little growth prospects, but steady cash flow. Often because these companies are in mature businesses. Take Davis and Henderson as an example. This is the company that prints your checks on behalf of your bank.

With the advent of electronic banking machines and the move towards internet banking, writing checks is not as popular as it once was. The implication is that any new growth prospect in this line of business will be driven by demographic rather than a new business model. However, on the plus side though, printing checks is a business with steady cash flow. That’s what makes this a decent income trust candidate.

Not all income trusts have the same characteristics. Some for example, have no real growth prospects, and have a volatile earnings stream. That’s not what you want when seeking income, and why buying individual trusts can be quite risky.

Perhaps a better approach is to buy a fund that invests in income trusts. Even better is one that distributes tax advantaged monthly income. Barclay’s is one company that has a family of such funds (see www.barclaysfunds.ca).

One in particular, is called the Baclays Advantaged S&P/TSX Income Trust Index Fund (symbol BAI.UN, listed TSX). “The Fund seeks to replicate, to the extent possible, the total return (price appreciation and distributions), net of expenses, of the S&P/TSX Capped Income Trust Index and to provide investors with a regular, leveled, stable, stream of tax-efficient monthly distributions consisting of capital gains and return of capital in an amount that matches, to the extent possible, the distributions paid on the income trusts included in the Index.”

In short, the Fund pays out its net taxable income to investors and pays a monthly distribution. What’s interesting, is that these distributions typically consist of capital gains and return of capital.

The cash flow represented as a return of capital is not subject to tax, although it does reduce your cost base which will come into play when you sell the units. So, the return of capital constitutes a deferral of income, which ultimately will be taken in as a capital gain. And since capital gains are taxed at a lower rate than distributions of interest, dividends and other investment income, this Fund offers investors a more advantageous after-tax return than could be achieved with a direct holding of income trusts.

Finally, a portfolio should also hold some growth assets, which is typically represented by equity type investments. And here too, you want to consider tax efficiency. When looking at equity funds for example, be mindful of things like turnover rates. Typically the higher the turnover, the larger the tax bill.

That said, sometimes a high turnover is the appropriate strategy. But in such cases, your advisor should be able to explain why a high portfolio turnover makes sense. Specifically, have your advisor demonstrate that the high turnover portfolio beat a passive benchmark (which by definition has a low turnover) by a wide enough margin to justify the increase in taxes payable.

In the end taxes are probably the most important factor when we look at wealth creation. Unfortunately, for most investors, it is only an afterthought, that hits home when they see their accountant.