The 18-Month Money
A client has $75,000 from the sale of a rental property and needs the money in 18 months for a down payment. She is in a 40% marginal tax bracket, has $20,000 of TFSA room and $30,000 of RRSP room. Her advisor compares four options: (A) an 18-month GIC at 4.20% compounded annually; (B) a balanced mutual fund with a 2.00% front-end load, a 2.10% MER, and an expected gross return of 6.00%; (C) a broad Canadian equity ETF with a 0.10% MER, expected gross return of 7.00%, a $9.99 commission, and a 0.05% bid-ask spread; (D) a segregated fund with a 2.80% MER, a 3% surrender charge in year one and 2% in year two, and a 100% maturity guarantee at 10 years. The client says she wants 'the best return but cannot lose money.'
1. Calculate approximate after-fee, after-tax terminal values for options A and B over 18 months. Assume the GIC is taxable and the fund's return is entirely deferred capital gain taxed at 50% inclusion. State your assumptions.
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Assumptions: 18 months = 1.5 years; GIC interest is taxed at 40% at maturity; the mutual fund return is fully deferred and taxed as a capital gain with a 50% inclusion rate; ignore fund distributions and fees other than those stated.
Option A: GIC
- Terminal value before tax: $75,000 × (1.042)^1.5 = $75,000 × 1.06366 = $79,774
- Interest: $4,774
- Tax at 40%: $1,910
- After-tax value: $77,864
- Effective annual after-tax return is roughly 2.5%.
Option B: Balanced mutual fund
- Front-end load: $75,000 × 2.00% = $1,500; invested amount = $73,500
- Net return after MER: 6.00% − 2.10% = 3.90%
- Terminal value: $73,500 × (1.039)^1.5 = $73,500 × 1.05907 = $77,842
- Gain: $4,342
- Taxable gain at 50% inclusion: $2,171
- Tax at 40%: $868
- After-tax value: $76,974
The GIC is ahead by about $890 after tax. Without the load, the fund would be worth about $79,430 before tax, or $78,544 after tax. The load alone costs roughly $1,570. If the fund pays taxable distributions, its result would be worse.
If the GIC were held in a TFSA, its value would be $79,774 tax-free. The fund in a TFSA would be worth $77,842, still below the GIC.
2. Evaluate options C and D against the client's liquidity need and loss aversion.
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Option C: Equity ETF The expected net return is 7.00% − 0.10% = 6.90%. On a simple projection:
- $75,000 × (1.069)^1.5 ≈ $82,900 before tax and trading costs
- Less $9.99 commission and about $37.50 of spread
- After 20% effective capital gains tax, roughly $81,300
That looks best on an expected-return basis, but the client needs the money in 18 months. An equity ETF can fall 20% or more in that period. The expected return is not a promised return, and the downside is incompatible with a down payment. The small commission and spread are not the issue; volatility is.
Option D: Segregated fund The 100% maturity guarantee applies at the 10-year maturity or on death, not at 18 months. If she exits in year two, a 2% surrender charge may apply, and the guarantee does not protect her. The 2.80% MER is a heavy drag. The insurance features are valuable for long-horizon estate or guarantee needs, not for an 18-month liquidity need.
Conclusion: C is unsuitable because of equity risk, and D is unsuitable because the guarantee does not match the horizon and the cost is high. The client's statement 'best return but cannot lose' is internally inconsistent. For this goal, capital preservation and liquidity must come first.
3. Recommend an allocation and explain how using the TFSA or RRSP changes the comparison.
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Recommendation: Keep the down payment in a low-risk, liquid vehicle. A reasonable structure is:
- $20,000 in a TFSA GIC or short-term government bond ETF, if the TFSA is not needed for another goal.
- $55,000 in a taxable 18-month GIC or a short-term bond ladder.
- No equity exposure for the down-payment money unless the client has other assets that could cover a shortfall and explicitly accepts the risk.
TFSA effect: GIC interest is fully taxable in a non-registered account but tax-free in a TFSA. Using the TFSA raises the after-tax GIC result from about $77,864 to $79,774. The TFSA is the better shelter for the fixed-income piece because the client is in a 40% bracket and the time horizon is short.
RRSP effect: An RRSP contribution gives a deduction now, but withdrawals are fully taxable. The Home Buyers' Plan may allow a withdrawal for a first-time buyer, but the amount must be repaid and the 18-month horizon makes the RRSP less flexible. The RRSP is better left for long-term retirement savings rather than a short-term down payment.
If the client has additional long-term money, keep that separate and invest it according to a longer-horizon plan. Do not let the expected return of equities tempt her into risking the down payment.