With the RRSP season in full swing, Frugal Focus is debating whether to focus on building a large nest egg or the passive income or cash flow that is generated by a portfolio. In retirement, of course, generating enough cash flow to cover living expenses without depleting capital is the preferable strategy.
During the asset accumulation phase, if assets are held in a tax-deferred account like a RRSP, the debate mostly boils down to six of one or half a dozen of the other. However, focussing on cash flow is not a winning strategy for taxable portfolios.
To see why, let us pretend that we are invested in an imaginary company that makes a nice profit selling some widgets. With its after-tax profits, the company has three options: (1) reinvest in its business, (2) pay a dividend or (3) buy back its shares. Ideally, management should choose an option (or a combination of options) that provides the highest rate of return for shareholders.
From a tax perspective, option #2 is the least attractive as the income stream is taxed on an ongoing basis. A superior business that is able to earn high rates of return on its reinvested profits allows true compounding to work its magic and would choose option #1. Option #3 is a tax-efficient way of rewarding shareholders. In taxable accounts, investors should prefer to buy businesses that mostly reward its shareholders through options #1 and #3, which would mean focussing on the size of the nest egg.
